AC499 Financial Report Analysis Unit 4
Liquidity ratios
Liquidity ratios
measure the ability of a company to repay its short-term debts and meet
unexpected cash needs.
Current ratio.
The
current ratio
is also called the working capital ratio, as working capital is the
difference between current assets and current liabilities. This ratio measures the ability of a
company to pay its current obligations using current assets. The current ratio is calculated by
dividing current assets by current liabilities.
Acid-test ratio.
The
acid-test ratio
is also called the
quick ratio
.
Quick assets
are defined as
cash, marketable (or short-term) securities, and accounts receivable and notes receivable, net
of the allowances for doubtful accounts. These assets are considered to be very liquid (easy to
obtain cash from the assets) and therefore, available for immediate use to pay obligations. The
acid-test ratio is calculated by dividing quick assets by current liabilities.
The traditional rule of thumb for this ratio has been 1:1. Anything below this level requires
further analysis of receivables to understand how often the company turns them into cash. It
may also indicate the company needs to establish a line of credit with a financial institution to
ensure the company has access to cash when it needs to pay its obligations.
Receivables turnover
. The
receivable turnover ratio
calculates the number of times in an
operating cycle (normally one year) the company collects its receivable balance. It is calculated
by dividing net credit sales by the average net receivables. Net credit sales is net sales less cash
sales. If cash sales are unknown, use net sales. Average net receivables is usually the balance of
net receivables at the beginning of the year plus the balance of net receivables at the end of the
year divided by two. If the company is cyclical, an average calculated on a reasonable basis for
the company's operations should be used such as monthly or quarterly.
Average collection period.
