Question

Balance Sheet Problem 1992 1993 1994 Annual Sales Growth (over prior yr) + 1% 0% +1% Current Ratio 3.5X 2X 1.2X Average Collection Period 25 days 30 days 55 days

What is happening to liquidity? What are some follow-up questions you would ask?

Answer 1

Liquidity ratio is determined by the combination of current ratio, quick ratio and average collection period.

Current ratio = Current Assets/Current liabilities

Quick ratio = (Current assets- inventory)/Current liabilities

Average collection period = Accounts receivable/(sales/365)

Current ratio determines ability of company to meet its current liabilities out of assets that can be disposed off within year. While, quick ratio defines ability to pay quickly all current liabilities.

In the given case, the current ratio is falling consistently which points out to deteriorating liquidity position. In order to determine quick position, the balances of current assets such as cash,cash equivalents and accounts receivables is to be asked.

Likewise average collection period is increasing meaning the days to collect receivables is increasing. Although sales has remained constant in year 1 and 3, collection period has more than doubled from 1992 to 1994. This reduction in cash collection has given rise to liquidity crunch in business which is evident in current ratio decline.

To provide detailed conclusion, balances of current assets such as cash,cash equivalents and accounts receivables along with sales need to be asked.