Liquidity ratios determine the company’s ability to pay its current obligations.
Before investing in a company, investors would like to know whether the company is profitable enough to pay their bills and dividends on time. This is a short-term measure of the company’s performance in terms of how much cash they have available and how much of their assets are being financed with debt.
Some common liquidity ratios:
1. Working Capital
Working capital = Current assets – Current liabilities
Working capital is how much current assets exceed current liabilities.
2. Current Ratio
Current ratio = Current assets / Current liabilities
Current ratio is a liquidity ratio that determines how much a company’s assets are financed by debt. Current ratio is a more dependable measure of a company’s liquidity than working capital. However, the current ratio does not provide any insight into what kind of assets the company owns, instead it just considers all current assets and all current liabilities. Current assets can include a large inventory or it can represent a large quantity of cash in the bank.
3. Inventory Turnover Ratio
Inventory turnover ratio = Cost of goods sold / Average inventory
This determines how many times throughout a year that the company sells off or turns over its inventory.
To determine the average inventory take the dollar value from the beginning of the accounting period and add the ending dollar value, then divide by two. This is the basic method; however, in Intermediate Accounting the issue becomes more complicated. This averaging method should suffice for an introductory accounting class.
4. Days in Inventory Ratio
Days in inventory ratio = 365 days / Inventory turnover ratio
Days in inventory determines the average number of days that an item in inventory sits on the shelf waiting for someone to purchase it.
5. Current Cash Debt Coverage Ratio
Current cash debt coverage ratio = Cash provided by operations / Average current liabilities
Current cash debt coverage ratio shows how much cash the company generates to pay liabilities.
6. Receivable Turnover Ratio
Receivable turnover ratio = Net credit sales / Average net receivables.
To determine the average receivables take the dollar value from the beginning of the accounting period and add the ending dollar value, then divide by two.
This ratio provides insight into the company’s credit policy. Have they increased sales by loosening credit? A loosening of credit may result in a high bad debt expense as the company may not be able to collect on its receivables.
7. Average Collection Period
Average collection period = 365 days / Receivable turnover ratio
This provides information on how long it takes for a company to collect its receivables.
