Liquidity Ratios

By Lauri Phillips

When analyzing the financial health of a firm there are four different groups of ratios that the analyst will consider. The groups are liquidity ratios, financial leverage ratios, efficiency ratios, and profitability ratios. In analyzing liquidity ratios, how they are defined and who uses them will be discussed. Problems associated with liquidity ratios will be addressed along with adjustments that are to be made to these ratios. Analysts will then be able to make correct assumptions about the liquidity of a firm.

The most used liquidity ratios are: ratios concerning receivables, inventory, working capital, current ratio, and acid test ratio. Other ratios related to the liquidity of a firm deal with the liquidity of its receivables and inventory. The ratios indicating the liquidity of a firm's receivables are days' sales in receivables, accounts receivable turnover, and account receivable turnover in days. Days' sales in receivables relate the amount of accounts receivable to the average daily sales on account. This is computed by gross receivables divided by average net sales per year. Short-term creditors will view this as an indication of a firm's liquidity. Internal analysts should compare it to the firm's credit terms to analyze if the firm is managing its receivables efficiently. The days' sales in receivables should be close to the firm's credit terms. Accounts receivable turnover indicates the liquidity of a firm's receivables. This is measured in times per year and is computed by net sales divided by average gross receivables. This figure can also be expressed in days by average gross receivables divided by average net sales for the year. Inventories are a significant asset of most firms; thus they are indicative of a firm's short-term debt paying ability. The liquidity of a firm's inventories can be analyzed through the use of the following ratios: days' sales in inventory, inventory turnover, and inventory turnover in days. In calculating days' sales in inventory the analyst would divide ending inventory by a daily average of cost of goods sold. The result is an estimate of the number of days that it will take for the firm to sell current inventory. Inventory turnover is calculated by cost of good sold divided by average inventory. This forecasts the liquidity of the inventory and is expressed as times per year. This formula can be revised by dividing average inventory by average daily cost of goods sold so that the turnover is expressed in the number of days. Creditors consider low inventory turnover as a liquidity risk associated with the firm. Management uses inventory turnover to utilize effective inventory control. If it is too high the firm may be losing sales due to not enough inventory. If too low there may be a problem with overstocking or obsolescence and the cost associated with carrying such inventory. Working capital is defined as current assets minus current liabilities. Analysts to determine the short-term solvency of a firm calculate this ratio. Management uses this ratio, since some loan agreements or bond indentures contain stipulations concerning minimum working capital requirements. A firm's current ratio is determined by current assets divided by current liabilities. This measures a firm's ability to meet is current liabilities out of its current assets. An average of two to one is usually the norm. A shorter operating cycle will result in a lower current ratio whereas; a longer operating cycle will result in a higher current ratio. The current ratio shows the size of the relationship between current assets and liabilities, enhancing the comparability between firms.

The acid test ratio (Quick ratio) is computed by current assets minus inventory divided by current liabilities. Thus this relates the most liquid assets to current liabilities. This is the most stringent test of liquidity. The usual guideline for the ratio is one to one. Short-term creditors will use this as an indication of a firm's ability to satisfy its short- term debt immediately. The management of the firm will have a greater difficulty borrowing short-term funds if the firm has a low quick ratio. If the ratio is very low, it is an indication that the firm will not be able to meet its short-term obligations. When using liquidity ratios the analyst will start with receivables and inventory, if a liquidity problem is suggested further analysis using the current and quick ratio will be used and the analyst will form an opinion accordingly.

Analysts use liquidity ratios to make judgments about a firm, but there are limitations to these ratios. The liquidity of a firm's receivables and inventories can be misleading if the firm's sales are seasonal and or the firm uses a natural business year (Gibson, Charles H. 1991 Financial Statement Analysis p.261 Cincinnati, OH: South-Western College Publishing). The analyst would then adjust the figures accordingly to compare with other firms. The valuation method used will have a major impact on the firm's liquidity of its inventory. Valuation of a firm's inventory under the Last-In-First-Out (LIFO) approach will cause an understatement of inventory with will carry over as an understated current ratio. The use of LIFO may cause a unrealistic days' sales in inventory and a much higher inventory turnover. The analyst would take the valuation method used into account when comparing with other firms. One way to judge the liquidity of a firm is to use not only traditional liquidity measures but also consider certain cash flow ratios. In doing liquidity analysis cash flow information is more reliable than balance sheet or income statement information (Mills, Yamamura : __Journal of Accountancy __1998). The cash flow ratios that test for solvency and liquidity are: operating cash flow (OCF), funds flow coverage (FFC), cash interest coverage (CIC), and cash debt coverage (COC). Cash flow ratios determine the amount of cash generated over a period of time and compare that to short-term obligations. This gives a clearer picture if the firm has a liquidity problem in connection with its short-term debt paying ability. Operating cash flow is computed by dividing cash flow from operations by current liabilities. This shows the company's ability to generate the resources needed to meet current liabilities (Mills, Vamamura: __Journal of Accountancy__ 1998). The funds flow coverage ratio is computed by dividing earnings before interest, taxes plus depreciation and amortization (EBITDA) divided by interest plus tax adjusted debt repayment plus tax adjusted preferred dividends. This ratio will help determine if the firm can meet its commitments. A measurement of one from this ratio indicates that the firm can just barley meet its commitments, less than one indicates that borrowing is needed to meet current commitments. The cash interest coverage ratio is computed by the summation of cash flow from operations, interest paid, and taxes paid divided by interest paid. This will help the analyst determine the firm's ability to meet its interest payments. If the firm is highly leveraged it will have a low ratio and a ratio of less than one places serious concerns about a firm's ability to meet its interest payments. The cash debt coverage is calculated by operating cash flow minus cash dividends divided by current debt. This indicates the firm's ability to carry debt comfortably. The higher the ratio the higher the comfort level. All of the cash flow ratios are not uniform but vary by industry characteristics. The analyst would then adjust his assumptions accordingly to assess the liquidity of a firm.

References

Gibson, Charles H. (1998). Liquidity of Short-Term Assets; Related Debt-Paying Ability. Financial Statement Analysis. (pp.253-283). Cincinnati, Ohio: South-Western College Publishing.

Mills, John R. and Yamamura, Jeanne H. (October 1998). The power of cash flows: Journal of Accountancy [Online], vol. 186, 13 pages. <http: www.westwords.com/guffey/apa.html> [1999, November 22].

Siegel, Joel G. & Shim Jae K. & Hartman, Stephen W. (1998). Accounts Receivable Management. (pp.2-5). New York, New York: McGraw-Hill.

Siegel, Joel G. & Shim Jae K. & Hartman, Stephen W. (1998). Accounts Receivable Ratios. (pp.6-8). New York, New York: McGraw-Hill.

Siegel, Joel G. & Shim Jae K. & Hartman, Stephen W. (1998). Acid-Test (Quick) Ratio (pp. 8-9). New York, New York: McGraw-Hill.

Siegel, Joel G. & Shim Jae K. & Hartman, Stephen W. (1998). Inventory Ratios (pp.166-167). New York, New York: McGraw-Hill.

Viscione, Jerry A. (1983). Liquidity Ratios. (pp.15-24). New York, New York: National Association of Credit Management.