Market trivia

Understanding financial ratios

Liquidity Ratios provide information about a firm’s ability to meet its short-term financial obligations.

The short-term obligations are the ones recorded under current liabilities that come due within one financial year. Short term assets are the current assets.

There are three important ratios and two frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.

The current ratio is equal to total current assets divided by total current liabilities. This indicates the extent to which current liabilities can be paid off through current assets. Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm’s assets are working to grow the business.

Typical values for the current ratio vary by firm and industry. For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns. Therefore this has to be compared with the industry average to determine if the ratio is indicative of adequate liquidity.

Quick Ratio

One drawback of the current ratio is that it assumes that all current assets can be converted into cash in order to meet short term obligations.

However we know that this is highly untrue.

Firms carry inventory which may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets.

The quick ratio is also called the acid test ratio, is equal to liquid current assets divided by current liabilities. It indicates the extent to which current liabilities can be paid off through liquid current assets. The quick ratio is defined as follows:

The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. These assets essentially are current assets less inventory. The quick ratio often is referred to as the acid test.