Liquidity Ratios

Working Capital:

Working capital compares current assets to current liabilities, and serves as the liquid reserve available to satisfy contingencies and uncertainties. A high working capital balance is mandated if the entity is unable to borrow on short notice. The ratio indicates the short-term solvency of a business and in determining if a firm can pay its current liabilities when due.

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Formula:

Current Assets – Current Liabilities

Acid Test (Quick) Ratio:

A measurement of the liquidity position of the business. The quick ratio compares the cash plus cash equivalents and accounts receivable to the current liabilities. The primary difference between the current ratio and the quick ratio is the quick ratio does not include inventory and prepaid expenses in the calculation. Consequently, a business’s quick ratio will be lower than its current ratio. It is a stringent test of liquidity.

 

Formula:

Cash + Marketable Securities + Accounts Receivable
Current Liabilities

Current Ratio:

Provides an indication of the liquidity of the business by comparing the amount of current assets to current liabilities. A business’s current assets generally consist of cash, marketable securities, accounts receivable, and inventories. Current liabilities include accounts payable, current maturities of long-term debt, accrued income taxes, and other accrued expenses that are due within one year. In general, businesses prefer to have at least one dollar of current assets for every dollar of current liabilities. However, the normal current ratio fluctuates from industry to industry. A current ratio significantly higher than the industry average could indicate the existence of redundant assets. Conversely, a current ratio significantly lower than the industry average could indicate a lack of liquidity.

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Formula:

Current Assets
Current Liabilities

Cash Ratio:

Indicates a conservative view of liquidity such as when a company has pledged its receivables and its inventory, or the analyst suspects severe liquidity problems with inventory and receivables.

Liquidity-ratio

Formula:

Cash Equivalents + Marketable Securities
Current Liabilities

Post Author: Muraya Muya