Liquidity Ratios

Chapter 17: Finish the Financials - Page 17.5

Liquidity Ratios

Liquidity ratios focus on cash position and ability to meet obligations.

Current Ratio: short-term assets divided by short-term liabilities. This gives a view of a business' cash position and ability to meet short-term commitments.
Quick Ratio: this is the same as the current ratio, except that inventories are first subtracted from short-term assets before they are divided by short-term liabilities. Many financial experts consider this a better measurement of liquidity than the current ratio, because inventory is so often not convertible to real cash in a short period of time.
Net Working Capital: subtract short-term liabilities from short-term assets. This is another measure of cash position.
Interest Coverage: profit before interest and taxes (operating profit) divided by total interest payments. A measure of how much a business is burdened by servicing its own debt.

These are all measures of the overall financial position of a company and its ability to pay its debt. They are very important to bankers and for loan applications. The acid test (included with additional ratios in the following section) is generally considered the best measure of a company's ability to pay all its obligations without problems. Acceptable measures vary by industry. Some industries are quite heavy on plant and equipment assets, and others, such as service businesses, have few long-term assets.

Additional Common Ratios

These additional ratios are also quite common.

Assets to Sales: assets divided by sales.
Debt/Assets: total liabilities divided by total assets.
Current Debt/Total Assets: divides short-term (current) liabilities by total assets.
Acid Test: short-term assets (minus accounts receivable and inventory), divided by short-term liabilities.
Asset Turnover: a repetition of the same ratio in activity ratios above (Total Assets Turnover).
Sales/Net Worth: total sales divided by net worth.
Dividend Payout: dividends divided by net profit.

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