Financial Analysis: Liquidity Ratios
Last we mentioned fundamental analysis, we discussed profitability ratios, a way to measure how well a company makes money. Today, we look at liquidity ratios as a way to use financial statements to glean information on how well a company can pay its short-term bills. The three most common of these ratios are the current ratio, quick ratio, and cash flow ratio.
The current ratio is defined as current assets divided by current liabilities – both quantities available on the balance sheet. Usually, a current ratio greater than 1 is important to ensure that a company will remain solvent given its current financial situation. Lower current ratios are good for shareholders as it shows that more of the company’s assets are working to grow the business.
The current ratio can prevent a problem for company’s that have high inventory turns but keep a lot of its current assets in inventory. To ascertain that this is not a problem in a quick manner, an investor can turn to the quick ratio which is similar to the current ratio but only takes into account what the company can use to quickly use to pay off its current liabilities. The basic formula for this would be current assets minus inventory divided by current liabilities. This is very conservative as it essentially assumes that inventory is worthless when in nearly all cases inventory should provide value. The quick ratio is sometimes referred to as the acid test ratio.
The final most conservative measure of a company’s liquidity is the cash flow ratio which is a look at whether or not a company has enough money from its current operations to pay off its current liabilities. It’s defined as operating cash flow divided by current liabilities. A cash flow ratio greater than 1 is usually a relatively good indicator of solid financial health as this implies that if the company would be viable so long as it focused on its core operations. Here we need to revisit the idea of free cash flow which we mentioned in “It’s Not All About Earnings.”
While operating cash flow attempts to give us an idea for the cash that a business should generate from its operations. it does have some adjustments made for depreciation and does not take into account capital expenditures as a result it is not an accurate statement of how much cash a business generates in one specific time period. Since the cash flow ratio is based on the operating cash flow, the ratio gives an idea of the company’s liquidity only in a general sense. Should the company continue the operations as they are over the long term, then the company should not have problems with short term liquidity. If, however, you wanted an idea of whether or not the company was able to pay its current obligations today then it would be better to adjust operating cash flow to arrive at a free cash flow number to use in the cash flow ratio.
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Comments
Clare… I found one site that provides for financial statement analysis of all public companies, industries and also for private companies. I used it in my classes: http://www.ventureline.com. Take a look.
[...] we look at current ratio which is a liquidity ratio. The goal here is to identify companies which should comfortably be able to service it’s [...]
[...] view working capital as strictly current assets – current liabilities and view it as a glorified quick ratio. Working capital analysis, however, is much more useful than simply a measure of [...]
Hi
Your site is great, I just stumbled across it. I am currently carrying out my first investor type analysis so this is very useful. I also found the finance owl site at http://www.thefinanceowl.com/ really useful, can you recommend any others?
Keep up the great site!!!
Clare