Evaluating a Company’s Solvency: Information Conveyed by Internal Liquidity Ratios

Financial ratios are much more than just a bunch of numbers that are thrown into a formula, taken for a spin, to spit out a random number. Quite the contrary, analysts use financial ratios to deduce meaningful relationships between certain values reported on companies’ financial statements.

One set of ratios, that is, internal liquidity ratios, evaluate a company’s short term liabilities, such as accounts payable (creditors) or notes payable, and compare them to its current assets, such as cash, marketable securities, or account receivables (debtors).

Current Ratio

The current ratio is perhaps the most popular among liquidity ratios, evaluating the relationship between a company’s current assets and current liabilities. The formula for calculating the current ratio is as follows:

Current Ratio = Current Assets / Current Liabilities

If a company’s current assets exceed its liabilities more than two times, the company is considered to have sufficient cash and near-cash coverage of its short-term financial obligations. However, if the company’s current liabilities are greater than its assets, then an analyst may have a valid reason to doubt the company’s short-term financial strength.

Quick Ratio (Acid Test)

The current ratio is a sort of a “catch all” liquidity ratio since in its numerator are included total current assets, parts of which may not be very liquid, such as inventories. For that reason, some analysts prefer not to use the current ratio and rather opt for the quick ratio (also referred to as the acid test), because it excludes inventories from the numerator, and as such is considered a more conservative liquidity measure.

The formula for calculating the quick ratio is as follows:

Quick Ratio = Cash + Marketable Securities + Receivables / Current Liabilities

From the quick ratio formula, it is observable that the numerator only includes the so-called quick assets, which are assumed to be more easily convertible into cash at values closer to their book values. As a result, the acid test indicates whether a company can run its business even when times are bad because of having sufficient cash and near-cash reserves. Note, however, that the time horizon in case of all current assets is short-term, only up to a year’s time.

Cash Ratio

The cash ratio is the most conservative of all liquidity ratios because its numerator includes only cash and marketable securities. However, it is not exactly one among the more commonly used liquidity ratios. The formula for the cash ratio is as follows:

Cash Ratio = Cash + Marketable Securities / Current Liabilities

It is obvious that the cash ratio compares only the most liquid of assets against a company’s current liabilities to see how much near-cash is available at any point in time during the measured period to cover a company’s short-term liabilities.

Investors would be wise to remember that just as a company is not analysed in isolation from the overall economy and industry, liquidity ratios should also not be compared in a vacuum in and by themselves. Once ratios have been calculated, they should be compared to the company’s competitors and any discrepancies should be approached with suspicion, even when skewed more to the positive side.

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