Successfully managing your business involves much more than comparing profitability and performance with previous periods and competitors within your industry. To ensure effectiveness you must evaluate beyond sales and profitability and read between the lines of your financial statements.

We must understand business liquidity ratios.

Ratio analysis allows you to identify and quantify your company’s strengths and weaknesses, evaluate its financial position, and understand the risks that you may be facing.

While ratio analysis is an extremely useful comparative technique, ratios are not complete and can be misleading. Ratio analysis is only truly effective when comparing like with like. If businesses are not similar to each other, ratio analysis will not provide a meaningful comparison of the performance of those businesses. If you were comparing the ratios of a wholesale chemist with ratios of a restaurant, for example, this would not be comparing like with like. Another example would be if company A recognizes sales when cash is received while company B recognizes sales when they are invoiced.

Non-quantitative factors will also contribute to the success or failure of your business. Financial accounts do not provide all the pertinent information for decision making, therefore, other factor such as economic climate, inflation and the relative strengths of competitors, must also be considered. The balance sheet provides a snap shot of the business at a particular point in time and ratios based on balance sheet figures, such as liquidity ratios, may not be representative of the financial position of the business for the year as a whole.

It is also important to note that the results of ratio analysis are dependent on the quality of the financial statements.

Despite this, ratios when used in conjunction with various other business evaluation processes, are invaluable.

LIQUIDITY RATIOS: WHAT YOUR BUSINESS NEEDS TO KNOW

Liquidity Ratios

While profitability is essential for the survival and growth of any business, it cannot be assumed that it’s the only thing you must consider when assessing the financial health of your business. The businesses ability to meet its commitments as they fall due must be evaluated.

The 2 main measures of liquidity are the current ratio and the acid-test ratio.

1) Current Ratio (Also known as the working capital ratio)

Current ratio = Current assets : Current liabilities

liquidity ratios - current ratio

The current ratio reflects the business’s ability to pay its short-term liabilities using its current assets. It essentially involves assessing the health of a business. It compares assets that will become liquid in approximately 12 months with liabilities which will be due for payment in approximately 12 months. These are referred to as short-term assets and short-term liabilities, or current assets and current liabilities.

The current ratio measures the extent your current assets cover your current liabilities. With current liabilities, the company has a limited amount of time to pay. As a result, a business will look at its current assets such as cash, cash equivalents, and marketable securities, that can be easily converted into cash in the short term. Therefore, if a business has a lot of current assets it will find it easier to pay its current liabilities as they fall due.

The current ratio expresses a business’s current liabilities in terms of current assets. The optimum level or rule of thumb is considered to be 2:1, however, each industry is different. When calculating this ratio for your business use your industry norm as a benchmark for comparison. Comparison of other businesses in the same industry will generally produce the most meaningful results. Acceptable ratios will differ between industries but a ratio between 1.5 and 3 are generally considered healthy.

An excessively high ratio, greater than 2:1, could indicate inefficiency in managing working capital. It raises questions concerning the amount of funds tied up in current assets. Overly high inventory levels, receivables and high cash levels, could be contributing to concerns. Having funds tied up in these assets prevent them from being used elsewhere. As a result, a high current ratio could indicate that the business is not efficiently using its current assets or short-term financing.

A current ratio of less than 2:1 could signal liquidity issues and poor financial health. It doesn’t necessarily indicate the business will go bankrupt, as it could secure other financing to meet its obligations.

A ratio of 1 would indicate your current assets equal your current liabilities. This would be considered the middle ground as it’s not extremely risky, nor is it completely safe. A ratio of 1 means that you would have to sell all of your current assets to pay your current liabilities.

For example, if a business has a current ratio of 3 this would mean that the business has 3 times as many current assets than current liabilities. The higher the current ratio, the easier the business will find it to pay it’s current debts as they fall due for payment. A business with insufficient current assets may have to sell some of its long-term assets to pay its current debts. In this case, it would usually indicate the business is not generating enough from its operations to support its activities and is making a loss.

It is important to note that a large purchases made in preparation for coming growth, or sale of an unnecessary asset, can suddenly change a business’s current ratio.

Investors and creditors will use the current ratio to assess a business’s liquidity and overall debt burden, and the impact of such on the business’s cash flow.

Current Ratio = Current Assets/Current Liabilities

Liabilities $ Assets $
Share capital 1,000,000 Fixed assets 1,400,000
General reserve 650,000 Inventory 150,000
Profit and loss account 250,000 Accounts receivable 450,000
Accounts payable 350,000 Cash and bank 250,000
_______ _______
2,250,000 2,250,000
_______ _______

Current assets:   Current liabilities:
Inventory 150,000   Accounts payable 350,000
Accounts receivable 450,000
Cash and bank 250,000
______ ______
Total current assets 850,000   Total current liabilities 350,000
______ ______

Current ratio = Current assets/Current liabilities

= 850,000 / 350,000

= 2.43

2) Acid Test Ratio (also known as the quick ratio)

Acid test ratio = Current assets – stock : Current Liabilities

liquidity ratios - acid test ratio

The acid test ratio shows provided that creditors and debtors are paid at roughly the same time, a view can be made as to whether a business has sufficient liquid resources to meet its current liabilities. It demonstrates how well a company can quickly convert its assets into cash to meets a short-term debt as it falls due.

Quick assets are assets that can be converted to cash quickly. These include assets such as cash, cash equivalents, short-term investments and current account receivables, for example. Inventory are removed from the analysis as they are the least liquid of the current assets, meaning that it is the slowest to convert into cash. Current liabilities usually included are bank overdraft, trade payables, tax, social security, and dividends approved but not yet paid.

The businesses ability to respond quickly to current debts becomes evident in this ratio. 1:1 is considered to be the benchmark but this will vary greatly from industry to industry and can be influenced by the relationship you have established with your suppliers. A quick ratio of 1 will indicate the business can pay its current liabilities using quick assets and will not need to sell any long-term assets. A business will not want to sell any of its long-term assets to pay current debts as long-term assets are used by the business to generate revenue.

If a business has to sell its long-term assets to pay its current liabilities, this will indicate to investors and creditors that the business’s current operations are not making sufficient profits to pay current debts.

Inventory problems are often highlighted through the acid test ratio. Excessive stock levels raise concerns regarding obsolescence and slow moving inventory. Higher quick ratios are generally more favourable as it shows that the business has more quick assets than current liabilities. A quick ratio of 2 would indicate that the business has twice as many quick assets than current liabilities. A higher acid test ratio highlights a more liquid current position for the business.

Fixed Assets $  $
Equipment  14,000
Current Assets
Inventory 17,500
Accounts receivable 20,000
Bank 2,500
 40,000
 Less Current Liabilities
 Accounts Payable  10,000  30,000
 44,000

 –

Current assets:  $   Current liabilities:  $
Inventory 17,500   Accounts payable 10,000
Accounts receivable 20,000
Cash and bank 2,500
_____ _____
Total current assets 40,000   Total current liabilities 10,000
_____ _____

Acid test ratio = Current assets less Inventory/Current liabilities

= (40,000 – 17,500) / 10,000

= 2.25

Example

Here, we will look at examples of two businesses; Bob’s Company and Mike’s Company.

Both companies have the same level of sales $144,000 and identical gross profits of $48,000. It would be easy to assume that both companies would, therefore, have similar financial health.

However, when we evaluate further we can see that there are major differences in their liquidity levels.

Liquidity Ratios: What Your Business Needs To Know

When we remove less liquid assets (inventory) from the equation, we can see that Mike’s Company is not as liquid as Bob’s Company and could succumb to financial distress as it may have difficulty responding quickly to obligations as they arise. However, a company with a low acid test ratio may actually have no problem in paying its trade payables if they have a sufficient overdraft facility.

The above analysis demonstrates the importance of not considering the current ratio in isolation. It should be calculated in conjunction with the acid test ratio.

It also highlights the importance of not simply relying on profitability as a means of assessing the financial health of a company. We must dig deeper and evaluate our liquidity ratios position. Cash flow forecasts can help us further take control of our credit and better manage liquidity.

3) Cash Ratio (also known as the cash asset ratio)

Cash ratio = Cash + Cash equivalents
                           Current liabilities

The cash ratio measures the amount of cash, cash equivalents, or invested funds that form part of the business’s current assets to cover current liabilities.  The ratio excludes inventory and accounts receivable.

Remember, inventory is included in the current ratio and accounts receivable is included in the quick ratio. The cash ratio measures the ability of the business to use its cash and cash equivalents to pay its current financial obligations. If a business holds a large amount of cash on hand it will have a high cash ratio.

It’s important to note the cash ratio measures cash balances at a specific point in time. As a result, this can frequently vary when receivables are collected or suppliers are paid.

The cash ratio is the most conservative of the three short-term liquidity ratios. A cash ratio of 1:1 is seen as a reasonable measure of a businesses ability to use its cash/cash equivalents, to meet its current debt. However, the majority of businesses will not have enough cash/cash equivalents to fully cover all of its current liabilities and this is not necessarily a bad thing.

Using this ratio, a business would not focus on achieving above 1:1. This is because maintaining high levels of cash assets to cover current liabilities, could be seen as poor asset utilization. Money tied up unnecessarily in current assets could be used in other profit generating activities or returned to shareholders. A cash ratio less than 1 means the business would need to use other short-term assets to fully pay its current liabilities.

Example 1

XYZ Company has the following current assets and current liabilities:

Current assets:  $   Current liabilities:  $
Cash equivalent 800,000
Cash 200,000
_____ _____
Total current assets 1,000,000   Total current liabilities 2,000,000
_____ _____

Cash ratio = 1,000,000/2,000,000

=.5

Example 2

Company ABC has the following assets and liabilities:

Assets: $ Liabilities: $
Inventory 100,000  Current liabilities 155,000
Accounts receivable 45,000  Non-current liabilities  215,000
Prepayments 8,000
Marketable securities 15,000
Cash 102,000
 Total Assets 270,000  Total Liabilities 370,000
Cash Ratio = Cash + Cash equivalents
——————-Current liabilities
Cash ratio = (102,000 + 15,000)/155,000
Cash Ratio = 0.75

4) Cash Conversion Cycle (Also known as the operating cycle)

Cash conversion cycle = Days inventory outstanding + Days sales outstanding – Days payable outstanding

Days inventory outstanding = Inventory/Cost of sales X 365 days

** The inventory figure used is average inventory. To calculate this, add this year’s opening inventory figure which is the previous year end amount and this year’s closing inventory figure. These figure can be found in the balance sheet. Then divide this figure by 2 to obtain an average amount of inventory for the year.

Days sales outstanding = Account receivable/Net credit sales X 365 days

** The accounts receivable figure used is average accounts receivable. To calculate this, add this year’s opening accounts receivable figure which is the previous year end amount and this year’s closing accounts receivable figure. These figure can be found in the balance sheet. Then divide this figure by 2 to obtain an average amount of accounts receivable for the year.

Days payable outstanding = Accounts payable/Cost of sales X 365 days

** The accounts payable figure used is average accounts payable. To calculate this, add this year’s opening accounts payable figure which is the previous year end amount and this year’s closing accounts payable figure. These figure can be found in the balance sheet. Then divide this figure by 2 to obtain an average amount of accounts payable for the year.

Example

Company A makes a product, which usually spends 8 days in their warehouse. It usually takes 17 days to collect on amounts owed by customers for each product.

Company A takes 15 days to pay its supplier for the parts to make that product.

Company A’s cash conversion cycle would be:

Cash Conversion Cycle = 8 + 17 – 15 = 10 days

What the cash conversion cycle means is that Company A generates cash from its assets within 10 days.

The cash conversion cycle is used to measure how many days it takes from initial cash outlay for inventory until the business receives cash from a customer. It measures how many days a company takes to sell inventory, collect receivables, and pay its accounts payable. The cash conversion cycle determines how long an investment is locked up in production before turning it into cash, as well as reflecting the business’s efficiency in managing its working capital assets.

Where a business offers an extended credit period to their customers, their cash conversion cycle will be longer as it will increase the time it takes to receive payment from customers. Similarly, an increase in inventory due to overproduction or poor purchasing decisions, for example, will also increase the length of the cash conversion cycle. This combined with a short period of credit from suppliers means that cash is being tied up in inventory and accounts receivables, and being used more quickly to pay accounts payable.

A long cash conversion cycle can be the difference between profit and bankruptcy, especially for a small business. A business needs cash to pay for expenses and meet obligations. If the cash conversion cycle is too long it will reduce the amount of cash available and increase the need for borrowing.

The shorter this cycle, the more liquid the company’s working capital position will be, and its ability to pay off its current liabilities will be greater. Therefore, a shorter cash conversion cycle will add to a company’s liquidity and decrease the need for borrowing. It will also increase the ability of the business to take advantage of supplier discounts, while providing the business with an increased capacity to fund expansion into new products.

By looking at the individual items in the cash conversion cycle, you will be able to identify positive and negative trends in a business’s working capital assets and liabilities. For example, an increasing trend in days inventory outstanding could indicate decreasing demand for a company’s products.

When looking at the cash conversion cycle, it is important to note that different industries have different capital requirements and standards.

Example

$
Sales 767,000
Cost of sales 568,000
Current Assets
Average inventory 122,000
Average accounts receivable 124,000
 Bank  6,000
Current Liabilities
 Average accounts payable  107,000
 –
Cash conversion cycle = Days inventory outstanding + Days sales outstanding – Days payable outstanding

Days inventory outstanding = Inventory/Cost of sales X 365 days

Days inventory outstanding = 122,000/568,000 X 365 = 78 days

Days sales outstanding = Account receivable/Net credit sales X 365 days

Days sales outstanding = 124,000/767,000 X 365 = 59 days

Days payable outstanding = Accounts payable/Cost of sales X 365 days

Days payable outstanding = 107,000/568,000 X 365 days = 69 days

Cash conversion cycle = 78 days + 59 days – 69 days = 68 days

Further Information on Liquidity Ratios

Here’s a useful video that further helps to explain business liquidity ratios:


These articles are created to give you a basic understanding of business topics. If you enjoyed reading and feel it will benefit others, please feel free to share.

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