P2A.2.2 Financial Ratios - Liquidity

Question 1

Financial Ratios

Answer 1

Ratio = Mathematical relationship

Financial ratio = Financially meaningful mathematical relationship

Question 2

Users of Financial Ratios

Answer 2

Short-term Creditors = Liquidity Ratios
Long-term Creditors = Leverage Ratios
Investors = Profitability & Market Ratios
Managers = Virtually all Financial Ratios

Question 3

Liquidity Ratio Meaning

Answer 3

1. Measures the ability of a company to pay short-term obligations as they fall due.
2. Ratios only useful when compared to a benchmark such as prior year performance.

Question 4

Current Ratio

Answer 4

1. Considered the most basic ratio of liquidity.
2. Measures proportion of current resources that are available to satisfy current obligations.
3. Measures how many times current assets can pay for current obligations.
4. Ratio less than 1 usually indicates a liquidity problem.
5. Too high of ratio could mean excessive investments in current assets.

Question 5

Current Ratio Formula

Answer 5

Current Ratio = Current Assets / Current Liabilities

CHANGES IN:
INCREASES TO CURRENT ASSETS = AN INCREASE IN CURRENT RATIO;
DECREASES TO CURRENT ASSETS = A DECREASE IN CURRENT RATIO;
INCREASES TO CURRENT LIABILITIES = A DECREASE IN CURRENT RATIO;
DECREASES TO CURRENT LIABILITIES = AN INCREASE IN CURRENT RATIO

Question 6

Quick (Acid-Test) Ratio

Answer 6

1. More conservative liquidity ratio than current ratio.
2. Quick assets = Cash, marketable securities and AR.
3. Measures debt-paying ability without liquidating inventory.
4. Measures how many times quick assets can pay for current obligations.

Question 7

Quick (Acid-Test) Ratio Formula

Answer 7

Quick Ratio = Cash + Marketable securities + Accounts receivables / Current Liabilities

CHANGES IN:
INCREASES TO QUICK ASSETS = AN INCREASE IN QUICK RATIO;
DECREASES TO QUICK ASSETS = A DECREASE IN QUICK RATIO;
INCREASES TO CURRENT LIABILITIES = A DECREASE IN QUICK RATIO;
DECREASES TO CURRENT LIABILITIES = AN INCREASE IN QUICK RATIO

Question 8

Cash Ratio

Answer 8

1. Most conservative liquidity ratio.
2. Cash = Cash + Marketable securities
3. Measures how many times cash assets can pay for current obligations.

Question 9

Cash Ratio Formula

Answer 9

Cash Ratio = Cash + marketable securities / Current Liabilities

CHANGES IN:
INCREASES TO CASH ASSETS = AN INCREASE IN CASH RATIO;
DECREASES TO CASH ASSETS = A DECREASE IN CASH RATIO;
INCREASES TO CURRENT LIABILITIES = A DECREASE IN CASH RATIO;
DECREASES TO CURRENT LIABILITIES = AN INCREASE IN CASH RATIO

Question 10

Cash Flow Ratio

Answer 10

1. Measures availability of net cash provided by operating activities to settle current obligations.
2. Measures how many times operating cash flow can pay for current obligations.

Question 11

Cash Flow Formula

Answer 11

Cash Flow = Operating Cash Flow / Current Liabilities

CHANGES IN:
INCREASES TO CURRENT ASSETS (NEGATIVE CASH FLOW) = A DECREASE IN CASH FLOW RATIO;
DECREASES TO CURRENT ASSETS (POSITIVE CASH FLOW) = AN INCREASE IN CASH FLOW RATIO;
INCREASES TO CURRENT LIABILITIES (POSITIVE CASH FLOW) = AN INCREASE IN CASH FLOW RATIO;
DECREASES TO CURRENT LIABILITIES (NEGATIVE CASH FLOW) = AN DECREASE IN CASH FLOW RATIO

Question 12

Net Working Capital

Answer 12

1. Measures net current resources (working capital) in relation to the level of total assets.

Question 13

Net Working Capital Ratio

Answer 13

Net Working Capital = Current assets - Current liabilities / Total assets

CHANGES IN:
INCREASES TO CURRENT ASSETS = AN INCREASE IN NET WORKING CAPITAL RATIO;
DECREASES TO CURRENT ASSETS = A DECREASE IN NET WORKING CAPITAL RATIO;
INCREASES TO CURRENT LIABILITIES = A DECREASE IN NET WORKING CAPITAL RATIO;
DECREASES TO CURRENT LIABILITIES = AN INCREASE IN NET WORKING CAPITAL RATIO

Question 14

Net Working Capital Turnover

Answer 14

Measures the movement of current assets.

= Sales / Working Capital