Liquidity Ratios
What nuances are there to the current ratio?
A mediocre company with a current ratio under one may have problems meeting its short-term debts, which can lead to cash flow problems and bankruptcy. However, many companies with durable competitive advantages have current ratios under one simply because they don't need the "liquidity cushion" of a company with poorer economics. Thus, the current ratio is primarily useful in determining the liquidity of a marginal-to-average business.
What are current assets?
Current assets is the company's assets that are expected to be converted to cash in the coming year.
What are current liabilities?
Current liabilities is the company's debt that is coming due in the current year.
List the liquidity ratios.
Current Ratio Quick Ratio Cash Ratio
How is the current ratio calculated?
Current Ratio = Current Assets / Current Liabilities
What's a good cash ratio?
A cash ratio above one indicates that the company can immediately pay its current liabilities in cash. A cash ratio below one indicates that it cannot.
What's a good current ratio?
A current ratio greater than one is considered good, because the company's short-term obligations are covered. Anything below one is considered problematic, because the company may have a hard time paying its creditors.
What's a good quick ratio?
A value above one means the company can immediately pay off its current liabilities using its liquid assets. A value below one indicates that it cannot.
How is the cash ratio calculated?
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
What is the purpose of liquidity ratios?
Liquidity ratios measure a company's ability to meet short-term debt obligations without raising additional capital.
How is the quick ratio calculated?
Quick Ratio = Liquid Assets / Current Liabilities Liquid Assets = Current Assets - Inventories - Prepaid Expenses. Alternatively, Liquid Assets = Cash + Cash Equivalents + Marketable Securities + Accounts Receivable
What is the cash ratio?
The cash ratio indicates the number of times a company could cover its current liabilities using only its cash and cash equivalents.
What are some reasons that having strong earning power can actually reduce a company's current ratio?
The company can easily cover its current liabilities using cash from day-to-day operations, so it doesn't need to hold cash. The company can easily tap into the cheap, short-term commercial paper market if it needs additional cash. The company can pay out generous dividends and make stock purchases, both of which diminish cash reserves.
What is the purpose of the current ratio?
The current ratio is a measure of a company's ability to cover its debts in the coming year.
What is the quick ratio?
The quick ratio measures the number of times a company could cover its current liabilities with its most liquid assets (e.g., cash, cash equivalents, marketable securities, and accounts receivable). While similar to the current ratio, it excludes inventory and prepaid expenses since they can take weeks or months to turn into cash. The quick ratio is also known as the acid-test ratio.
