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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