Liquidity Ratios - Calculations

Question 1

What is Net working capital?

Answer 1

Net working capital = Current assets - Current liabilities

Net working capital reports the resources the company would have to continue operating in the short run if it had to liquidate all of its current liabilities at once

Question 2

What is Current ratio?

Answer 2

Current ratio = Current assets / Current liabilities

A low ratio indicates a possible solvency problem. An overly high ratio indicates that management may not be investing idle assets productively

Question 3

What is the general principle when evaluating the reasonableness of a company’s current ratio?

Answer 3

The general principle is that the current ratio should be proportional to the operating cycle. Thus, a shorter cycle may justify a lower ratio

For example, a grocery store has a short operating cycle and can survive with a lower current ratio than cold a gold mining company, which has a much longer operating cycle

Question 4

How should the quality of receivables and inventory be considered when evaluating a company’s current ratio?

Answer 4

The quality of accounts receivable and merchandise inventory should be considered before evaluating the current ratio

A low receivables turnover (net credit sales / avg. AR) and a low inventory turnover (COS / avg. Inv) indicates a need for a higher current ratio

Question 5

What is the Cash ratio?

Answer 5

The cash ratio is the most conservative variation of the current ratio:

= (Cash + Marketable securities) / Current liabilities

Question 6

What is the Cash flow ratio?

Answer 6

The cash flow ratio reflects the significance of cash flow for settling obligations as they become due

= Cash flow from operations / Current liabilities

Question 7

What is the Net working capital ratio?

Answer 7

The net working capital ratio is the most conservative of the working capital ratios:

= (Current assets - Current liabilities) / Total assets

Question 8

What is the concept of the liquidity of current liabilities?

Answer 8

The liquidity of current liabilities is the ease with which a firm can issue new debt or raise new structured (convertible, puttable, callable, etc.) funds

The liquidity of current liabilities indicates the ease of funding or availability of sources of funding. A firm’s ability to borrow in the financial markets is generally a function of its size, reputation, creditworthiness and capital levels

Raising liquidity during an adverse situation often requires a combination of both asset liquidity and liability liquidity