Go beyond current ratio to determine liquidity

Free Online Articles Directory

Why Submit Articles?
Top Authors
Top Articles
FAQ
AB Answers

Publish Article

0 && $.browser.msie ) {
var ie_version = parseInt($.browser.version);
if(ie_version Hello Guest
Login

Email

Password

Remember me?
Lost Password?

Home Page > Finance > Go beyond current ratio to determine liquidity

Go beyond current ratio to determine liquidity

Edit Article |

Posted: Sep 22, 2009 |Comments: 0
| Views: 361 |

]]>

Accounting Basics and Mechanics – Working capital and Liquidity Measurements

Liquidity refers to an entities ability to hold adequate cash reserves to pay any or all of its current liabilities. In essence it is the capacity of a firm to turn its current assets into cash quickly. This is important to any business who intends to pay their accounts payable on time and maintain a high credit rating. In order to pay it’s obligations on time a firm must first sell its merchandise inventory, turn that into accounts receivable, then collect the receivable to generate the cash they need. Therefore the old adage “cash is king” cannot be true enough when it comes to paying current liabilities on time. In fact, it is said that a company is more likely to survive a compression on profits than getting through a shortage of cash. It is not surprising that credit managers in particular are more interested in a firm’s short term financial strength than its overall profitability trend. They want to know not only that a customer has the ability to repay its debt, but whether or not they can repay it on time. To remove the guesswork credit managers rely on a number of complimentary ratios that go beyond the current ratio to determine liquidity.

A customary method of looking at liquidity is through the current ratio, a comparison of current assets to current liabilities. The current ratio is computed by dividing current assets by current liabilities and displays the quotient as a ratio. For example, if current assets are $100,000, and current liabilities are $60,000, the current ratio is computed by dividing $100,000 by $60,000 arriving at a current ratio of 1:1.33. This means for every dollar the company owes it has $1.33 in available assets to pay it. The quick ratio is an adaptation of the current ratio and a slightly better indicator of liquidity. This ratio takes inventory out of the equation and compares cash and accounts receivable balances to current liabilities. For example if cash is $20,000, accounts receivable is $40,000 and current liabilities $35,000, the quick ratio is computed by dividing cash and accounts receivable ($20,000 + $40,000) by $35,000 arriving at a quick ratio of 1:1.71. Although this ratio appears to indicate adequate liquidity, there might be certain asset valuations lurking in these numbers to indicate otherwise.

As a rule of thumb the current ratio and the quick ratio are only analytically adequate indicators of financial liquidity. Due to the monetary valuations assigned to cash, accounts receivable and inventory, these stand alone numbers may not produce an accurate measurement of liquid assets. Financial practices such as keeping bad debts open in the trade receivable balance, allowing customers to pay beyond payment terms, or inflated inventory levels caused by inadequate valuation or poor sales will distort the liquidity ratios. Therefore, any assessment of liquidity based on the current and quick ratios must be examined closely by adding inventory and accounts receivable cash conversion measurements to the working capital assessment.

The generation of cash receipts resulting from selling inventory and collecting accounts receivable is what financial managers refer to as the cash conversion cycle. Two important ratios help determine the efficiency of this cycle. First is the days inventory outstanding (DIO) ratio. This ratio is computed by dividing cost of sales by the average inventory, returning a figure representing the number of times inventory turns during the period. For example, if average inventory at the end of the fiscal year is $31,000 and the cost of sales is $240,000 inventory turnover is computed by dividing cost of sales ($240,000) by average inventory ($31,000) showing inventory turns 7.7 times each year. If you divide the turnover rate into 365 days you can convert the turnover rate into a number indicating the number of days of inventory the entity has on hand (365 days / 7.7 turns) or 47 days of inventory on hand.

Once inventory is sold it sometimes creates immediate cash for the firm but more likely creates an accounts receivable balance that needs to be collected. Determining how efficient a company is collecting its accounts receivable is found by calculating its days sales outstanding (DSO). This ratio is computed by dividing total outstanding receivables by the total credit sales for the period being evaluated, times the number of days in the period being evaluated. For example, if total accounts receivable at the end of the fiscal year is $15,000 and total credit sales for the year is $450,000 the DSO for the year is computed by dividing accounts receivable ($15,000) by credit sales ($450,000) times 360 days arriving at a DSO of 12 days. The lower the number, the more efficient the company is at collecting its cash.

Summation: Liquidity is important to know and can be found by looking at working capital and through the current ratio and the quick ratio. These two ratios alone can hide operational deficiencies that erode an entities actual liquidity. Known together as the cash conversion cycle, two additional ratios give a clearer view as to the components of equity and can expose hidden deficiencies. The cash conversion cycle consists of the days inventory outstanding ratio and the days sales outstanding ratios.

Retrieved from “http://www.articlesbase.com/finance-articles/go-beyond-current-ratio-to-determine-liquidity-1259736.html”

(ArticlesBase SC #1259736)

Liked this article? Click here to publish it on your website or blog, it’s free and easy!

Bob Mennor -
About the Author:

]]>

Questions and Answers

Ask our experts your Finance related questions here…200 Characters left

What are the perspectives of using ratio analysis ?
How can gap analysis be applied to the system development life cycle?

Rate this Article

1
2
3
4
5

vote(s)
0 vote(s)

Feedback
RSS
Print
Email
Re-Publish