Liquidity Ratios

Liquidity Ratios

Financial ratio used to determine a debtor's ability to pay off current debt obligations without raising external capital.

Average Collection Period

Helps gauge the liquidity of accounts receivable, the ability of the firm to collect from customers. Also provides information about a company's credit policies. For example, if the average collection period is increasing over time or is higher than the industry average, the firm's credit policies could be too lenient and accounts receivable not sufficiently liquid. The loosening of credit could be necessary at times to boost sales, but at an increasing cost to the firm. On the other hand, if credit policies are too restrictive, as reflected in an average collection period that is shortening and less than industry competitors, the firm may be losing qualified customers. The average collection period should be compared with the firm's stated credit policies. In general, a lower ratio is more favorable than a higher one. A low ratio indicates that the organization is collecting payments faster.

Days Payable Outstanding

The average number of days it takes to pay payables in cash. This ratio offers insight into a firm's pattern of payments to suppliers. Delaying payment for payables may be desirable if the firm is meeting terms required by the supplier and can earn a return on cash held. If a company's days payable outstanding is lower than the industry benchmark, then the company is not using its cash as long as its competitors in the industry. By paying bills earlier than necessary, the company remains at a disadvantage.

Cash Flow Liquidity Ratio

The ratio uses in the numerator, as an approximation of cash resources, cash and marketable securities, which are truly liquid current assets, and cash flow from operating activities, which represents the amount of cash generated from the firm's operations, such as the ability to sell inventory and collect the cash.

Cash Conversion Cycle

The normal operating cycle of a firm (in days) that consists of buying or manufacturing inventory, with some purchases on credit and the creation of accounts payable; selling inventory, with some sales on credit and the creation of accounts receivable; and collecting the cash. Usually a company acquires inventory on credit, which results on accounts payable. A company can also sell products on credit, which results in accounts receivable. Therefore, cash is not a factor until the company pays the accounts payable and collects the accounts receivable, and the timing becomes an important aspect of business from the point of view of cash management by the company. The CCC helps the analyst understand why cash flow generation has improved or deteriorated by analyzing the key balance sheet accounts - accounts receivable, inventory, and accounts payable - that affect cash flow from operating activities. Essentially, the CCC represent how fast a company can convert the invested cash from start (investment) to end (returns). The lower this number, the better it is for a business.

Current Ratio

Measures a company's ability to pay short-term and long-term obligations. Mainly used to give an idea of a company's ability to pay back its liabilities (debt and accounts payable) with its assets (cash, marketable securities, inventory, accounts receivable). Can be used to make a rough estimate of a company's financial health. A ratio under 1 indicates that a company's liabilities are greater than its assets and suggests whether the company in question is able to pay off its obligations as they come due. Likewise, a relatively high ratio could indicate that it's assets aren't being used. Companies in the retail industry typically have current ratios below 1

Days Inventory Held

The average number of days it takes to sell inventory to customers, measuring the efficiency of the firm in managing its inventory. Generally, a low number of days inventory held is a sign of efficient management; the faster inventory sells, the fewer funds tied up in inventory. On the other hand, too low a number could indicate under-stocking and lost orders, a decrease in prices, a shortage of materials, or more sales than planned. A high number of days inventory held could be the result of carrying too much inventory or stocking inventory that is obsolete, slow-moving, or inferior; however, there may be legitimate reasons to stockpile inventory, such as increased demand, expansion and opening of new retail stores, or an expected strike. The type of industry is important in assessing days inventory held. It is expected that florists and produce retailers would have a relatively low days inventory held because they deal in perishable products, whereas retailers of jewelry or farm equipment would have higher days inventory held, but higher profit margins.

Quick or Acid-Test Ratio

This ratio eliminates inventory, considered the least liquid current asset and the most likely source of losses. A figure of 1 is considered normal, as it indicates that the company is fully equipped with sufficient assets that can be instantly liquidated to pay off its current liabilities. A company that has a quick ratio of less than 1 may not be able to fully pay off its current liabilities in the short term, while a company having a quick ratio higher than 1 can instantly get rid of its current liabilities. For instance, a quick ratio of 1.5 indicates that a company has $1.50 of liquid assets available to cover each $1 of its current liabilities.