Liquidity Ratios: The Current Ratio and the Quick Ratio Explained
There are two liquidity ratios that are generally used to offer an insight into the liquidity of the firm. These are the Current Ratio and the Quick Ratio.
Current ratio = Current assets / Current liabilities
Current liabilities are generally defined as any that need to be settled within 12 months. Current assets can be essentially reduced to cash, stock and any debtors.
The current ratio is designed to be a broad guide. As with most ratios, the results cannot be readily compared with any other firms or industries as for obvious reasons, every one is different. It is accepted that a ratio of between 1.5 and 2.0 is prudent.
However, a high ratio can be a bad thing. Whilst it may show careful financial management, it may also suggest that assets could be used more profitably and the company holds too much cash or inventory.
Quick ratio = (Current assets - stock) / Current liabilities
The quick ratio is designed to show how much could be instantly realisable into cash. The thinking is that if all debts needed to be settled tomorrow or next week, could they be? A result of less than 1 suggests that the debts could not be settled at short notice.
These liquidity ratios can only offer a guide to the financial state of a firm. They can only be taken as a part of the whole. However, as with any analysis, they can highlight potential financial problems in the future.
Astute or more experienced readers may be scratching their heads as this point. After all, it is important to bear in mind that a company does not pay it's bills or debts by using a
! Companies pay their bills with cash and so understanding the cash flow is likely to be more important to most people. These ratios really only come into play when a company is in very serious financial trouble - by definition this is not the best place to look for long-term investing profits.
However, if times really are that bad for the company you are invested in, this
will help you to work it out quickly.
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