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Liquidity Ratios and Formulas
Liquidity ratios - The liquidity ratios help investors determine the short-term solvency of a firm. For the most part, investors look for liquidity ratios greater than 1. This shows the examined company has more short-term assets than short-term liabilities. Ratios less than one may indicate possible near-term cash shortages.
Area of caution: Some industries, as a practice, have low liquidity ratios. For example, retail stores are notorious for having very low liquidity ratios, such as quick ratios (.3 to .7). This is due to their need to have significant amounts of inventory on hand. Because of this, liquidity ratios may be misleading in some industries. So, when considering the the liquidity ratio for a company, expand your research to include industry competitors as well.
Common liquidity ratios include:
- Current Ratio
- Quick Ratio
- Cash Ratio
Liquidity Ratios and Formulas
This is a brief description of the liquidity ratio formulas. For an in-depth review contact Paul.
The current ratio is simply: Current Assets / Current Liabilities.
This formula allows for a very quick assessment of a firm's solvency. If the ratio is 1 or greater, the firm is solvent for the short-term. If the ratio falls below 1, possible solvency issues may arise in the near term.
Quick Ratio or Acid Test Ratio: (Current Assets -Inventory) / Current Liabilities
The quick ratio slightly varies from the current ratio because inventory is backed out of the current asset, before dividing by the current liabilities. This action will almost make the quick ratio lower than the current ratio. Some extreme results may arise from the use of the ratio. For example, businesses that sell services will have little if any reduction in the ratio. In contrast, retail stores, will have huge fluctuations due to their need for large inventory. These examples, again, highlight the need to compare liquidity ratios to their perspective industries as a whole for a well-rounded understanding.
Cash Ratio: (Cash + Marketable Securities) / Current Liabilities
The cash ratio is important to calculate and understand for two reasons. First, cash is the most liquid form of an asset. Knowing the cash position of a firm helps an investor understand a firm's ability to repay their current debt. Second, a high cash ratio may indicate poor cash management practices of a firm's management team. A firm hold significant amounts of cash is not using their assets to their optimum abilities. This is due to the low return cash returns to a firm. In situations with high cash ratios, management should invest their excess in short term securities or return the funds to investors through dividends. This action ensures assets are used to their greatest effect.
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