Liquidity ratios focuses on cash flows, measures a company's ability to meet its short - term obligations. Liquidity measures how quickly assets are converted into cash. Liquidity ratios also measure the ability to pay off short - term obligations.
The level of liquidity needed differs from one industry to another. A particular company's liquidity position may also vary according to the anticipated need for funds at any given time. Larger companies are usually better able to control the level and composition of their liabilities than smaller companies. Therefore, they may have more potential funding sources, including public capital and money markets.
Common liquidity ratios are presented in the following table. These liquidity ratios reflect a company's position at a point in time and, therefore, typically use data from the ending balance sheet and not the averages. The current, quick, and cash ratios reflect three measures of a company’s ability to pay current liabilities. Each uses a progressively stricter definition of liquid assets.
· Current ratio Current assets Current liabilities
· Quick ratio Cash + short-term marketable Current liabilities
Investments + receivables
· Cash ratio Cash + short-term marketable Current liabilities
·Cash conversion cycle DOH + DSO – number of days of payable
· Current ratio: This ratio expresses current assets in relation to current liabilities. A higher ratio indicates a higher level of liquidity (a greater ability to meet short - term obligations). A current ratio of 1.0 would indicate that the book value of its current assets exactly equals the book value of its current liabilities.
A lower ratio indicates less liquidity, implying a greater reliance on operating cash flow and outside financing to meet short - term obligations. Liquidity affects the company’s capacity to take on debt.
· Quick ratio: The quick ratio is more conservative than the current ratio because it includes only the more liquid current assets in relation to current liabilities. Like the current ratio, a higher quick ratio indicates greater liquidity.
The quick ratio reflects the fact that certain current assets — such as prepaid expenses, some taxes, and employee - related prepayments — represent costs of the current period that have been paid in advance and cannot be converted back into cash. This ratio also shows the fact that inventory might not be easily and quickly converted into cash, and that a company would probably not be able to sell all of its inventory for an amount equal to its carrying value, especially if it were required to sell the inventory quickly.
In situations where inventories are illiquid, the quick ratio may be a better indicator of liquidity than the current ratio.
· Cash ratio: The cash ratio normally represents a reliable measure of an individual entity’s liquidity in a crisis situation. Only highly marketable short - term investments and cash are included. In a general market crisis, the fair value of marketable securities could decrease significantly as a result of market factors, in which case even this ratio might not provide reliable information.
· Cash conversion cycle (net operating cycle): This formula indicates the amount of time that elapses from the point when a company invests in working capital until the point at which the company collects cash. In the typical course of events, a merchandising company acquires inventory on credit, incurring accounts payable. The company then sells that inventory on credit, increasing accounts receivable. Afterwards, it pays out cash to settle its accounts payable, and it collects cash in settlement of its accounts receivable. The time between the outlay of cash and the collection of cash is called the cash conversion cycle. A shorter cash conversion cycle indicates greater liquidity and vice versa.
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