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Liquidity ratios

Liquidity is a measure of a company’s creditworthiness because it affects solvency and its ability to obtain capital at low borrowing costs and exploit profitable opportunities.

A company’s liquidity primarily depends on the balance between its current assets and current liabilities, which is measured using the current ratio and quick ratio.

Current ratio

Current ratio equals current assets divided by current liabilities. A higher current ratio is better, but it also depends on its trend, its comparison with ratios of competitors and the availability of profitable opportunity in long-term assets.

\[ Current\ Ratio=\frac{Current\ Assets}{Current\ Liabilities} \]

Quick ratio

Quick ratio (also called acid-test ratio) equals quick assets (cash, short-term marketable securities and receivables) divided by current liabilities.

Liquidity depends on how quickly a company converts its inventories to sales/receivables, its receivables to cash and how delayed its payments to accounts payable become due.

Inventory turnover ratio

Inventory turnover ratio measures the number of takes inventories are sold. The number of days of inventories (also called average inventory period) measures how long it takes inventories to be sold.

\[ Inventory\ Turnover\ Ratio=\frac{Cost\ of\ Goods\ Sold\ (COGS)}{Average\ Inventory} \] \[ Number\ of\ days\ of\ inventories\ =\ \frac{Average\ Inventory}{Daily\ COGS}=\frac{365}{Inventory\ Turnover} \]

Accounts receivable turnover

Accounts receivable turnover measures the number of times accounts receivables are created and collected. Days sales outstanding (also called days in receivables or number of days of receivables) measures the number of days it takes to collect cash from receivables on average.

\[ Accounts\ Receivable\ Turnover\ =\ \frac{Credit\ Sales}{Average\ Accounts\ Receivable} \] \[ DSO\ =\ \frac{365}{Accounts\ Receivable\ Turnover} \]

Accounts receivable turnover and DSO must be analyzed keeping in view the credit terms and the relationship between sales and credit terms and industry practices.

Number of days of payables measure how long a company takes in paying its creditors.

\[ Number\ of\ days\ of\ payables\ =\ \frac{Average\ Accounts\ Payable}{Purchases\ /\ 365} \]

All these ratios make sense when they are compared across time and between different companies in the same industry. For example, a high inventory turnover may be due to efficient production or inventory shortages.

Operating cycle and cash conversion cycle

The operating cycle represent the number of days a company takes in selling its inventories and then receiving associated cash. It is the sum of the number of days of inventory and the number of days of receivables.

Net operating cycle (also called cash conversion cycle) equals the operating cycle minus number of days of payable. In general, shorter cycles are better.

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