Management uses financial data to determine the success for the company. In the first two parts of the series, I discussed profitability and efficiency ratios. In this blog, I will be discussing liquidity ratios that management uses to meet their short term goals. The higher the ratio, the better the company is able to pay their short term debts. Liquidity is a measure of near term financial health.
The current ratio can be defined as a company’s ability to have enough liquid assets in order to meet their short term obligations. Liquid assets are assets that can be readily turned into cash, such as bank accounts, accounts receivable, etc. Every company wants this ratio to be above 1 as it explains that the company has enough resources to pay its short term debts, such as accounts payable and payroll liabilities. The current ratio can be calcluated as current assets over current liabilities.
Current Ratio = Current Assets/Current Liabilities
Current Ratio = $10,000/$5,000 = 2.0
So this means that the company has 2 times the amount of resources to cover short term obligations.
The quick ratio is a more stringent test of solvency than the current ratio. It assesses the strength of the business to pay short-term obligations without selling inventory or considering prepaid expenses. The quick ratio measures the dollar amount of the most liquid assets available for each dollar of current liabilities. This ratio can be calculated as:
Quick Ratio = (Cash & Equivalents + Accounts Receivable + Marketable Securities)/Current Liabilities
Quick Ratio = ($3,000+$50,000 + $5,000)/$50,000 = 1.16
Operating Cash Flow Ratio
The operating cash flow ratio (OCF) shows how well the company’s cash flow from operations can cover current liabilities. Management usually relies on company cash flow to determine whether they can meet and pay short term debts or not. Profit and loss statements also tell whether company is profitable or not, but cash flow statements tell whether the company has positive or negative cash flow. This ratio can be calculated as:
OCF Ratio = Cash Flow from Operations / Current liabilities
OCF Ratio = $50,000/ $5,000 = 10.0
As with all financial ratios, their relevance is apparent when used comparatively or as a trend. When compared to other companies of similar size and industry, management can determine strengths and weaknesses. When viewed internally over a period of time, trends can be established to predict the effects of changes in operations.