There are many variations of liquidity solvency and

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There are many variations of liquidity, solvency, and coverage ratios. The basic idea is to construct measures that reflect a company's credit risk exposure. There is not one "best" financial ratio. Instead, as financial statement users, we want to use measures that capture the risk we are, most concerned with. It is also important to compute the ratios ourselves to ensure we know what is included and excluded from each ratio. 0.60 0.50 0.40 0.30 0.20 0.10 v / / / / 2008 2009 2010 2011 1\1 Operating Cash Flow to Debt Free Cash Flow to Debt Liquidity Analysis Liquidity refers to cash availability: how much cash a company has, and how much it can generate on short notice. In this section, we discuss several of the most common liquidity measures: the current ratio, working capital, and the quick ratio.' Current Ratio Current assets are assets that a company expects to convert into cash within the next operating cycle, which is typically a year. Current liabilities are those liabilities that come due within the next year. An excess of current assets over current liabilities (Current assets - Current liabilities), is known as net working capital or simply working capital. Positive working capital implies more expected cash inflows than cash outflows in the short run. The current ratio expresses working capital as a ratio and is computed as follows: C Current assets urrent ratio = ------- Current liabilities Positive working capital or a current ratio greater than 1.0 both imply more expected cash inflows than cash outflows in the short run. Generally, companies prefer a higher current ratio (more working capital); however, an excessively high current ratio can indicate inefficient asset use. A current ratio less than 1.0 (negative working capital) is not always a bad sign. For example, retail- ers carry inventory that is about the same value as accounts payable and, thus, working capital is near zero. If the inventory is sold as anticipated, sufficient cash will be generated to pay current liabilities. Other companies are especially efficient at managing working capital by minimizing 5 For simplicity, we compute ratios in this module using numbers reported instead of adjusted numbers. We also do this so that we can compare its ratios to other companies' ratios. An alternate, more exact, approach is to recompute all competitors' numbers and create adjusted industry-level ratios.
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Module 4 I Credit Risk Analysis and Interpretation 4-16 - 'ables and inventories and maximizing payables. Dell is the classic example of an efficient acturer with little to no working capital, 1.0 2011, Home Depot's current ratio was 1.33 and it has fluctuated within a range of 1.15 to - over the previous three years, as shown in the graphic. Home Depot is a cash-and-carry busi- and, thus, we do not expect its current ratio to be as high as companies that carry a high level ivables. Given that its current ratio exceeds 1.0, Home Depot seems reasonably liquid.
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