Showing posts with label quick ratio. Show all posts
Showing posts with label quick ratio. Show all posts

Saturday 17 December 2016

Working capital management is the main determinant in the liquidity position of a company.

Liquidity or Working Capital Ratios

Cash Conversion cycle is just one part of assessing the working capital position. 
Other is the computation of 
  • Current Ratio, 
  • Acid-test Ratio and 
  • Cash Ratio. 

Current Ratio

Current Ratio is the basic and the most used amongst the list of liquidity ratios. 
It is also known as working capital ratio and is stated as below:
Current Ratio= Current Assets/ Current Liabilities
The resultant figure represents the number of times current assets cover current liabilities. 
Higher the ratio better it is. 
However, this ratio can be higher even if cash is trapped in receivables and inventories.


Acid Test Ratio

Acid test ratio is also known as quick ratio and it considers only “highly” liquid assets in consideration.
Acid Test ratio = (Current Assets- Stock- prepaid expenses)/ Current Liabilities
Acid test ratio doesn't include inventories but does include receivables and so thought a refinement of current ratio may still mislead at times


Cash Ratio

This one is a further refinement of Acid Test ratio and considers only Cash and cash equivalents for the purpose of measuring liquidity. 
Cash Ratio = Cash + Cash equivalents / Current liabilities


The above ratios and Cash Conversion Cycle determine the working capital position of a company. 
However, we always maintain that one aspect of the entire financial position cannot be considered as representative of the total financial health of a company. 
So here are a few cautionary words for cases when you just have working capital figures to contend with.



Factors to consider when assessing working capital position of a Company

1.    Healthy and unhealthy working capital position can be generalized only according to the industry and sector an entity is operating in. Some entities by nature have higher liquidity and some low;
2.    Higher liquidity is not always favourable as it may indicate under-utilisation of resources and money. You will need to further dig in to find if this is the case;
3.    Consider recent sale, purchase, construction of an asset, pre-closure of loan or liquidation of a big liability owing to strategic decisions that affect liquidity tremendously;
4.    Change in trade terms, seasonal nature of goods sold also has a strong bearing on liquidity position.

Working capital management is extremely important for companies. 
It is the main determinant in the liquidity position of a company. 
Profitable companies can go bankrupt due to a paucity of liquidity.  

Sunday 18 April 2010

Measure short-term solvency and liquidity

Short-term solvency is the ability to meet short term debts from liquid assets.  Liquid assets include money on short-term deposit and trade receivables, but not inventories, which cannot be quickly turned into cash.


LIQUIDITY versus PROFITABILITY

In the short term liquidity is more essential to financial stability than profitability.  Cash generated from operating activities is a major source of liquid funds, as measured by the statement of cash flows.  There may be other priorities for funds from operating activities, therefore it is important to have sufficient liquid assets to meet short-term debts.



CASH FLOW

The cash operating cycle is the length of time between paying out cash for inputs and receiving cash from sales.  It is a useful measure of the time taken to generate cash.  Cash flow forecasts enable businesses to predict and deal with liquidity problems before they arise.  It is one of the most important measures of future solvency.


THE CURRENT RATIO

Current ratio =  Current assets / Current liabilities

This is a standard test of short-term solvency and simply measure if a business can meet its current liabilities from its current assets.  Depending upon the nature of the business, the current ratio should usually be greater than 1, depending upon the speed of inventory turnover.



THE QUICK RATIO (or ACID TEST RATIO)

Quick ratio = (Current assets less inventory) / Current liabilities

This is a more reliable short-term solvency measure because inventory is not easily convertible into cash for many businesses.  This ratio should be close to 1, depending upon the business.


INTERPRETING LOW AND HIGH RATIOS

Don't interpret current and quick ratios too literally.  Different businesses operate in different ways.  Low ratios are not always indicative of insolvency risk and high ratios are not always healthy.

LOW RATIOS.


For example, a high volume retailer, such as a supermarket could have healthy liquidity but very low current and quick ratios.  Supermarkets have relatively low inventories as their goods are mainly perishable and turnover quickly.  They have minimal receivables as customers pay in cash.  In addition, their purchasing power results in long trade payable payment periods.  Therefore overall - relatively low current assets and relatively high current liabilities.

HIGH RATIOS.


A poorly managed business with slow-selling inventories and many outstanding receivables may have high current and quick ratios.

Short-term solvency is the ability to pay short-term debts from liquid assets.


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Measuring Business Performance