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Liquidity Ratio
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Cash flow projections are the best measures of liquidity, but liquidity ratios can also be used. It is important to note that liquidity ratios are not current measures of liquidity, but historical measures of liquidity, as they draw on information from the financial statements that have been prepared.
Liquidity ratios essentially answer the question:
What is our ability to pay short term debt?
If an organisation is liquid, it will be able to settle its debts when they become due, without having to sell any assets. If an organisation is not liquid, it will need to take action, such as improving its debt collecting or negotiating later payment dates with suppliers.
The current ratio and the quick ratio measure liquidity. The numbers for these ratios can be found on the Balance Sheet. Events from these calculations therefore cannot be compared across different points in time, as the Balance Sheet is a reflection of a single point in time.
The Current Ratio
Current Ratio = Current Assets / Current Liabilities
How to interpret the ratio:
Current assets will provide the necessary cash to pay current liabilities. The bigger the ratio, the lower the risk that short-term debt will not be paid. The current ratio is expressed as a multiple of one. For example, 2:1 means that current assets are twice the amount of current liabilities. If the calculation is less than 1, then current liabilities are greater than current assets.
The Quick Ratio (or Acid Test Ratio)
Quick ratio = Current Assets – Inventory / Current Liabilities
How to interpret the ratio:
The quick ratio is a more conservative calculation that the current ratio, as it excludes inventory as a source of getting cash in to settle urgent debts. Converting inventory into cash requires selling the inventory and this could take some time. This ratio is the same as the current ratio, except that inventory is excluded.
Working Capital
Current assets – current liabilities = Working Capital
How to interpret this equation:
The subtraction of current liabilities from current assets is known as the working capital. Too much working capital implies that resources are being wasted which in turn affect return on capital. Too little working capital could mean a cash flow crisis. The current ratio and the quick ratio provide a guide for interpreting whether or not the working capital is adequate.
Click here to view a video that explains current ratio.