The Power of Numbers: Liquidity Ratios
Regular readers on the Business Roadmap Newsletter may be surprised to see another article on “The Power of Numbers” as we declared the “Profitability Ratios” article in our April issue to be the final in the series. Well, thanks to those clients who reminded us we missed Liquidity Ratios - one of our Ratios discussed in our general financial advice sheets.
Liquidity ratios relate to the ability of your business to quickly generate the cash needed to pay your bills. This makes these ratios of interest both to you (since the inability to meet your short term debts would be a problem that deserves your immediate attention), to your creditors and to lenders if you are seeking funding.
Current Ratio: this ratio gives an indication of whether your business has enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets, such as inventory shrinkage or collectable accounts. The current ratio is the standard measure of any business' financial health.
Formula: total current assets / total current liabilities
Example: a company has total current assets of $100,000 and total current liabilities of $75,000.
Current Ratio = $100,000 / $75,000 = 1.33
The result indicates the company has $1.33 of current assets for every dollar of current liability (1.33:1). The rule of thumb is 2:1 or better.
Generally speaking if the current ratio is too small a business will encounter problems in paying bills as they become due. On the other hand a current ratio that is too high may represent excessive cash balances, excessive inventories, or excessive accounts receivables consisting of many slow accounts. A financial ratio can be a guide to actions you need to take. For instance, if you decide your current ratio is too low you may be able to raise it by:
- Paying some debts
- Increasing your current assets from loans or other borrowings with a maturity of more than one year
- Converting non-current assets into current assets
- Increasing your current assets from new equity contributions
- Putting profits back into the business
The Quick Ratio (aka Acid Test Ratio) takes the current ratio one step further for companies with substantial inventory to indicate how well they can cover short term liability with current assets minus inventory value. Inventory is eliminated because it represents that portion of current assets that are most difficult to liquidate rapidly into cash.
Formula: (total current assets – inventory) / total current liabilities
A business with a large quantity of slow moving inventory would not be signaled of this by their current ratio but it will certainly be evident in their quick ratio calculation.
The rule of thumb is 1:1. A lower ratio indicates illiquidity. A higher ratio may imply unused funds. Apart from its importance to you, it can be used to evaluate the financial health of potential customers since it also indicates whether a business can pay off its debts quickly. A firm with a low quick ratio may be more likely to delay payments because its assets are tied up elsewhere.
Ratios are also very useful for making comparisons between your business and other businesses in your industry. For example, comparing ratios can indicate whether your business is holding unusually high inventory or collecting receivables more slowly than comparable organisations. These comparisons provide insight into areas where your business could improve its operations.
There is a wealth of financial ratio analysis tools available for analysing the different operations of a business, not just finance. Regular reporting of a judiciously chosen set will turn your raw figures into ‘real world’ performance measures that will give you a handle on managing the business more effectively.
SOURCE NOTE: Bullseye Business Solutions
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