LIQUIDITY RATIOS

The relationship of current assets to current liabilities is an important indicator of the degree to which a firm is liquid. Working capital and the components of working capital also provide measures of the liquidity of a firm. Ratios that directly measure a firm`s liquidity provide clues concerning whether or not a firm can pay its maturing obligations. The current (or working capital) ratio and the acid-Test (or quick) ratio are important ratios that are used to measure a firm`s liquidity.

Net working capital. Net working capital is equal to current assets less current liabilities. Current assets are those assets that are expected to be converted into cash or used up within 1 year. Current liabilities are those liabilities that must be paid within 1 year; they are paid out of current assets. Net working capital is a safety cushion to creditors. A large balance is required when the entity has difficulty borrowing on short notice. For Beta Manufacturing Company in 20×5 is:

Net working capital = Current assets ‑ Current liabilities;
= $800,000 ‑ $340,000;
= $460,000;

In 20×4, net working capital was $398,000 ($760,000 – $362,000). The increase in net working capital is a favorable sign.

CURRENT RATIO The current ratio expresses the relative relationship between current assets and current liabilities. The current ratio is computed as follows using data taken from the balance sheet of the Beta Manufacturing Company, Exhibit 2-3 of Chapter 2:

It is convenient to set the computations in the following format:

20×5 20×4
Current assets $800,000 $760,000
Current liabilities 340,000 362,000
Current ratio 2.35 2.10
The 20×5 ratio is interpreted to mean that there is $2.35 of current assets for each dollar for each dollar of current liabilities. This represents an improvement over 20×4. A rule of thumb suggests that a 2:1 ratio is ordinarily satisfactory, but this is by no means a necessarily reliable relationship. Consideration must also be given to industry practices, the firm`s operating cycle, and the mix of current assets. A very low current ratio would ordinarily cause for concern since cash flow problems appear imminent. An excessively high current ratio could suggest that the firm is not managing its current assets properly.

Quick (aciD-Test) RATIO A quick measure of the debt-paying ability of a company is referred to as the quick ratio or acid-Test ratio. The quick ratio expresses the relationship of quick assets (cash, marketable securities, and accounts receivable) to current liabilities. Inventory and prepaid expenses are not considered quick assets because they may not be easily convertible into cash. The acid-Test ratio is a more severe Test of a company`s short-term ability to pay debt than is the current ratio. A rule of thumb for the quick ratio is suggested as 1:1. Again, industry practices and the company`s special operating circumstances must be considered. The 20×5 and 20×4 acid-Test ratios of the Beta Manufacturing Company are computed as follows:

20×4 Quick ratio =($384.000/$362.000)=1.06For each $1 of current liabilities in 20×5, there is $1.30 of quick assets available to pay the obligations. There has been a significant improvement in the quick ratio.

Note:
Short-Term Creditors. A significant decline in the quick ratio indicates deterioration in the company`s liquidity, which could indicate the company`s inability to satisfy its maturing debt immediately, if it had to do so.
Financial Management. A lower quick ratio may mean that the company will have greater difficulty borrowing short-term funds. A very low ratio may indicate that the company will be unable to meet its short-term debt payments.

It is important to understand how various transactions affect particular ratios and net working capital. Selected transactions will be used to demonstrate this issue. Assume that a company has an acid-Test ratio of 2:1. The following transactions occurred and their effect on the acid-Test ratio and on net working capital is shown:

Acid-Test Ratio Net Working Capital
1.An account payable is paid in cash + 0
2.An account receivable is collected 0 0
3.Inventory is purchased for cash - 0
4.Inventory is purchased on account - 0
5.A cash dividend is declared - -
6.Land is purchased for cash - -
7.Land is purchased for common stock 0
8.Marketable securities are sold for cash at a loss - -
9.Marketable securities are purchased for cash 0 0
10.Bonds are purchased for cash and held as a long-term investment - -
11.Common stock is issued at discount for cash + +
12.The cash dividend declared earlier is distributed + 0
Other Liquidity Ratios. Two other popular liquidity ratios that a short-term creditor might be interested in are: the cash ratio and the cash burn rate. The cash ratio, also known as the doomsday ratio, is a more severe Test of liquidity than the acid-Test ratio. The cash ratio is computed by dividing cash by current liabilities:

(CASH/CURRENT LIABILITIES)

20×5 20×4 Trend
$40,000/ $340,000= 0.18 $30,000/ $362,000= 0.08 Improving
Note: This ratio is most relevant for companies in financial distress. The doomsday ratio name comes from the worst case assumption that the business ceases to exist and only the cash on hand is available to meet credit obligations. Suppose that a company is facing a strike and cash inflows begin to dry up. How long could the company keep running? One answer is given by the cash burn rate:

Cash burn rate = ([Current assets] / [Average daily operating expenses])

In 20×5, total operating expenses were $1,371,000 ($1,070,000 cost of goods sold + $301,000 operating expenses).

The daily average expense was $1,371,000/365 = $3,756.16 per day. The burn rate is thus =$800,000/$3,756.16= 212.98 days. Based on this, the company could hang on for about 7 months.

For 20×4:
The daily average expense = ($ 1.034.000 + $ 276.000)/365 = $3,589.04 per day
The burn rate = $760,000/$3,589.04 = 211.76 days.

This suggests that the burn rate is about the same.

Note: This ratio is most relevant for start-up companies that often have little in the way of revenues. A high value indicates no need for outside financing. It may also suggest that the company is in the mature or declining phase of the corporate life cycle.

The overall liquidity trend shows a slight improvement as reflected in the higher net working capital. Current and quick ratios display an improvement although they are behind the industry norms (see Exhibit 8-1 in Chapter 8 for industry averages). Further, cash-related ratios show a sign of improvement, as measured by the cash ratio and cash burn rate.

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