What Does "Liquidity Ratio" Mean?
When analyzing the financial statements of a company, analysts focus on three areas: profit, liquidity and capitalization. Liquidity is one of the most important issues because it measures a company's ability to pay its debts on a timely basis. Analysts use several financial ratios to gauge the liquidity of a company.
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Current Ratio
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The current ratio is calculated by taking a company's total current assets -- cash, receivables and inventory -- and dividing it by its current liabilities -- debts dues in less than 12 months.. The most desirable ratio 2 to 1. This means that the company has $2 in current assets for each $1 in current liabilities.
The reason to strive for this ratio is that the cash inflows of a company do not always match the outflows of cash. The due dates and amounts of current liabilities are very clear, whereas the timing of the receipt of funds is not always so clear. Cash inflow depends on the turnover rate of inventory and the timing of accounts receivable collection.
Acid-Test Ratio
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The acid-test ratio, a harsher measure of liquidity, is calculated by taking the sum of the company's cash balances plus its receivables and dividing it by the total current liabilities. Ideally, this ratio should be at least 1.5 to 1. Any ratio less than this number would indicate a very tight cash position, and the company would more than likely be having problems meeting its debt obligations on time
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Working Capital
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Working capital is calculated by taking total current assets and subtracting total current liabilities. Ideally, this results in a positive number. If the company is making a profit and has a positive cash flow, working capital should always be increasing.
Analysts track the working capital turnover by dividing total sales by the amount of working capital. If this ratio is very high, the company probably has tight liquidity and should be looking for ways to increase the working capital level, possibly by adding long-term debt or increased capitalization. A low working capital turnover ratio would mean that the company probably has excess working capital, and the managers should be thinking about redeploying these assets into more productive areas. A rough rule-of-thumb is to have a ratio of about 5 to 1.
Accounts Receivable Turnover
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The turnover rate of accounts receivable affects the firm's liquidity. Accounts receivable turnover is calculated by dividing the annual sales by the current balance of accounts receivable. For example, if a company's annual sales are $1.2 million and its accounts receivables are $100,000, then the turnover rate would be 12. If the company is selling on 30-day terms to its customers, then this would be a perfect ratio. Anything less than this number would indicate a slowness in collection of receivables and a tightening of liquidity.
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