Question

How can analysis and use of other related measures ( other than current ratio ) enhance the evaluation of liquidity ?

Answer 1

Some of the commonly used liquidity ratios used here in the financial analysis of a company. A balance sheet is provided as an example for calculating a company's financial position by measuring its liquidity, which is the ability to pay its current debt with its current assets. The information reflects two years of data for a hypothetical company.

The balance sheet data will also be used to calculate the current ratio, quick ratio, and net working capital, as well as provide an explanation of each as well as the meaning of changes from year to year. The results can be replicated for your own firm or one that you are interested in investing in.

In order to stay solvent, the firm must have a current ratio of at least 1.0 X, which means it can exactly meet its current debt obligations.

The current ratio shows how many times over the firm can pay its current debt obligations based on its assets. "Current" usually means a short time period of less than twelve months. The formula is:

Current Ratio = Current Assets/Current Liabilities.

The quick ratio or acid ratio is a more stringent test of liquidity than the current ratio. It looks at how well the company can meet its short-term debt obligations without having to sell any of its inventory to do so.

Inventory is the least liquid of all the current assets because you have to find a buyer for your inventory. Finding a buyer, especially in a slow economy, is not always possible. Therefore, firms want to be able to meet their short-term debt obligations without having to rely on selling inventory. In order to stay solvent and pay its short-term debt without selling inventory, the quick ratio must be at least 1.0 X and the formula is:

Quick Ratio = Current Assets-Inventory/Current Liabilities.

A company's net working capital is the difference between its current assets and current liabilities:

Net Working Capital = Current Assets - Current Liabilities

From this calculation, If you have positive net working capital with which to pay short-term debt obligations before you even calculate the current ratio. You should be able to see the relationship between the company's net working capital and its current ratio.

All of these above are the key components of a basic liquidity analysis for a business. More complex liquidity and cash analysis can be done for companies, but this simple liquidity analysis will get you started.

It's helpful, to have two- years of data for the firm, which provides information on the trend in the ratios, it is also important to compare the firm's ratios with the industry.