Liquidity-related ratios
1. Current relationship
This relationship can be calculated as follows,
Current Ratio = Current Assets/Current Liabilities
This index contemplates the identification of the organization’s ability to meet short-term liabilities. In general, a ratio between 2 and 3 is considered good. The smaller the ration means that the company has difficulty meeting short-term obligations.
In the case of a lower ratio, these variables can be further expanded. Liabilities in 3 months, 6 months, 9 months, 12 months, and whether current assets can be managed to meet liabilities in a timely manner.
2. Ratio of cash to current assets
This relationship can be calculated simply as follows,
Cash to CA = Cash/Current Assets
This ratio will highlight cash management, which is the most liquid asset. A higher ratio could indicate that the company is holding onto cash without thinking about investment opportunities.
3.Quick Asset Ratio
The Quick Assets Index only takes into account the most liquid assets and provides a better measure of a company’s liquidity.
Quick ratio = Current liquid assets (Cash, securities, accounts receivable) / Current liabilities
In this ratio, inventory and other low liquid assets are eliminated, giving a good indication of the company’s ability to meet current liabilities.
4. Cash Ratio
The cash ratio can be calculated as follows,
Cash Ratio = Cash and cash equivalents / Current liabilities
Accounts receivable are also eliminated in this ratio and therefore give an indication of the availability of immediate assets to cover current liabilities.
5. Accounts receivable turnover rate
This relationship can be calculated as follows,
Accounts Receivable Turnover Ratio = Sales Revenue / Average Accounts Receivable
The average accounts receivable can be calculated as follows,
Average Accounts Receivable = (Previous Accounts Receivable + Current Accounts Receivable)/2
This provides an indicator of the credit policy of the company mainly. A higher ratio implies that the company quickly charges its customers. A high ratio compared to the competition could indicate that the company’s credit policy is somewhat risk averse, as the company does not provide sufficient credit facilities and could be missing out on sales opportunities.
6. Average number of days pending
This relationship can be calculated as follows,
Non-Averaging: of days = 365 / Accounts Receivable Turnover
Therefore, this gives the number of days that accounts receivable are outstanding. If the ratio is expanded we can arrive at the following ratio,
Average Number of Days = (Average Accounts Receivable * 365)/Sales Revenue
This index gives an idea of the company’s credit management policy.
To reach a better understanding, I would analyze in depth,
a) Who are the suppliers of the company? What is the provider-by-provider breakdown based on credit performance?
b) Is the company dependent on few suppliers or does it have a large number of supplier bases?
7. Inventory turnover rate
This relationship can be calculated as follows,
Inventory Turnover = Cost of Goods Sold/Average Inventory
This ratio signifies the effectiveness of inventory management. A high ratio would indicate that the company is managing its inventory well, allowing it to manage working capital more effectively.
A very high ratio can also indicate that the company is not maintaining sufficient levels of inventory, leading to the loss of potential customers.
A company that practices concepts like just in time would have a very high inventory ratio.
a) How effective is the re-order level? How effective is storage?
b) What is the average delivery time of a supplier?
8. Turnover Ratio to Pay
This can be calculated as follows,
Billing Payable = Annual Purchases / Average Payable
This relationship can be further broken down into,
Annual Purchases = Cost of Goods Sold + Closing Inventory – Beginning Inventory
Average creditors = (Current creditors + Current creditors of the previous year)/2
This ratio explains how much credit the company uses from its suppliers. This ratio is calculated by checking credit ratings, and a low ratio could indicate that the business is not getting much credit from its suppliers.
This may be because,
a) The company does not have a good credit history with suppliers
b) If suppliers have a very high bargaining power they could negotiate a very low credit period
9. Average number of days pending payment
This relationship can be calculated as follows,
Average number of days pending payment = 365/billing due
This relationship is quite similar to the ration discussed in the previous section. This relationship tries to express the credit period in days.
This ratio is also defined as the average age of accounts payable.
10. Cash Conversion Cycle
This relationship can be calculated as follows,
Cash conversion cycle = average collection period + average number of days in stock – average payment age
This ratio highlights the speed of conversion of cash receipts. A high amount ratio could imply that the company has invested in portfolio sales, maintaining a greater number of days in stock and with a high collection period.
11. Defensive interval
This relationship can be calculated as follows,
Defensive interval = 365 * (cash + marketable securities + accounts receivable) / operating expenses
This relationship is used to identify the worst case scenario to identify how long the business can survive incurring its normal operating expenses without generating sales.
Operating expenses are financed from current assets and this gives the number of days that the company can survive without generating sales.
A higher ratio will imply that the company maintains a large amount of current assets. To conclude on the use of current asset ratios as the current ratio, one should consider the quick asset ratio.
