Liquidity Ratios

Liquidity ratios

Working capital

The working capital of current assets with current liability indicates the short-run solvency of the business. The inventory as reported may be much less than its replacement cost. The difference between the reported inventory amounts is normally material when the firm is using LIFO inventory. The difference may also be material when one of the other cost methods.

The current working capital amount should be compared with past amounts to determine if working capital is reasonable. Because the relative size of a firm maybe expanding or contracting, comparing the working capital of one firm with that of another firm is usually meaningless because of their size differences. If the working capital appears to be out of line, the reason should be found by analyzing the individual current asset and current liability accounts.

The current ratio

The current ratio is the ratio which uses to determine short term debt-paying ability. For many years, the guideline for the minimum current ratio has been 2.00. Until the mid-1960s, the typical firm successfully maintained a current ratio of 2.00 or better. Since that time, the current ratio of many firms has declined to a point below the 2.00 guideline. Currently, many firms are not successful in staying above a current ratio of 2.00. This indicates a decline in the liquidity of many firms. It also could indicate better control of receivables and/or inventory.

A comparison with industry averages should be made to determine the typical current ratio for similar firms. In some industries, a current ratio substantially below 2.00 is adequate, while other industries require a much larger ratio. In general, the short the operating cycle, the lower the current ratio. The longer the operating cycle, the higher the current ratio.

The quick ratio

The current ratio evaluates an enterprise's overall liquidity position, considering current assets and current liabilities. At times, it is desirable to access a more immediate position than that indicated by the current ratio. The acid-test or known as quick ratio relates the most liquid assets to current liabilities.

Inventory is removed from current assets when computing the acid-test ratio. Some of the reasons for removing inventory are that inventory may be slow-moving or possibly obsolete, and parts of the inventory may have been pledged to specific creditors.

For many years, the guideline for the minimum acid-test ratio was 1.00. A comparison should be made with the firm's past acid-test ratios and with major competitors and the industry averages. Some industries find that a ratio less than 1.00 is adequate, while others need a ratio greater than 1.00.

Profitability ratios

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