Liquidity as a Key Indicator

1. Current Ratio

This ratio can be calculated as follows,

Current Ratio = Current Assets/Current Liabilities

This ratio contemplates on identifying the organizations ability to meet shot term liabilities. Generally a ratio between 2 to 3 is considered good. The lower the ration it means that the company has difficulties in meeting the short term obligations.

In the case of lower ratio these variables can be further expanded. Liabilities within 3 months time, 6 months time, 9 months time, 12 months time and whether the current assets can be managed to meet the liabilities in a timely manner.

2. Cash to current Asset Ratio

This ratio can be simply calculated as follows,

Cash to CA = Cash/ Current Assets

This ratio will highlight the management of cash which the most liquid asset. Higher ratio could indicate that the company is holding on to cash without thinking of investment opportunities.

3. Quick Asset Ratio

Quick assets ratio only takes into account the most liquid assets and gives a better measurement of the company's liquidity.

Quick ratio = Liquid current assets (Cash, securities, accounts receivables)/ Current liabilities

In this ratio the inventory and other low liquid assets are removed thus gives a good indication of the company's ability to meet the current liabilities.

4. Cash Ratio

Cash ratio can be calculated as follows,

Cash Ratio = Cash and cash equivalents/ Current liabilities

In this ratio the account receivables are also removed and thus give an indication of the availability of immediate assets to cover up the current liabilities.

5. Receivable turnover Ratio

This ratio can be calculated as follows,

Receivable turnover ratio = Sales Revenue / average Receivables

Average receivables can be calculated as follows,

Average receivables = (Previous account receivables + current account receivables)/2

This provides an indicator of the company's credit policy mainly. Higher ratio implies that the company is collects dues from its customers quickly. A high ratio compared to competition might indicate that the company's credit policy somewhat risk averse where the company does not provide enough credit facility and might be loosing on sales opportunity.

6. Average Number of days receivable outstanding

This ratio can be calculated as follows,

Avg No: of days = 365 / Receivable Turn over

Thus this gives the number days the receivables are out standing. If the ratio is expanded we can arrive at the following ratio,

Avg No: of days = (Average Receivables * 365)/Sales Revenue

This ratio gives an insight to the credit management policy of the company.

To arrive at better insight you would analyze deep into,

a) Who are the company's suppliers? What is the breakdown supplier by supplier based on credit performance?

b) Is the company dependent on few suppliers or does it have a large number of supplier bases?

7. Inventory Turn over Ratio

This ratio can be calculated as follows,

Inventory Turnover = Cost of goods sold/average inventory

This ratio signifies the effectiveness of inventory management. A high ratio would indicate that the company is managing its inventory well which enables the company to manage the working capital more effectively.

A very high ratio also may indicate that the company does not maintain sufficient levels of inventory thus leading to loss of potential customers.

A company which is practicing concepts like just in time would have a very high inventory ratio.

a) How effective is the re-order level? How effective is warehousing?

b) What is the average lead time of a supplier?

8. Payable Turnover Ratio

This can be calculated as follows,

Payable turnover = Annual purchases / average parables

This ratio can be further broken down into,

Annual Purchases = Cost of goods sold + Closing inventory - Beginning inventory

Average payables = (Current payables + Current Payables in the previous year)/2

This ratio explains how much of credit the company uses from its suppliers. This ratio is calculated when checking the credit ratings and a low ration could indicate that the company does not get much credit from its suppliers.

This may be because,

a) The company does not have a good credit history with suppliers

b) If the suppliers have a very high bargaining power they might negotiate a very low credit period

9. Average Number of Days Parables Outstanding

This ratio can be calculates as follows,

Average number of days parables outstanding = 365/payable turnover

This ratio is quite similar to the ration discussed in the above section. This ratio tries to express the credit period using days.

This ratio is also defined as the average age of payables.

10. Cash Conversion Cycle

This ratio can be calculated as follows,

Cash conversion cycle = average collection period + average number of days in stock - average age of payables

This ratio highlights the speed of conversion of collections into cash. A high amount ratio could imply that the company has invested on sales in the pipeline maintaining higher number of days in stock and with high collection period.

11. Defensive Interval

This ratio can be calculated as follows,

Defensive interval = 365 * (cash + marketable securities + accounts receivable)/ operational expenses

This ratio is used to identify the worst case scenario to identify how long the company can survive incurring its normal operational expenses without generating sales.

Operational expenses are funded with the current assets and this gives the number of days the company can survive without generating sales.

A higher ratio will imply that the company is maintaining a lot of current assets. To conclude on the utilization of current assets ratios like current ratio, quick asset ratio should be considered.