This document discusses liquidity ratios, which are calculated using numbers from a company's balance sheet and reveal its ability to pay off short-term debts. There are two main liquidity ratios: the current ratio, which measures a company's ability to pay off current liabilities with its current assets, and the acid test ratio, which measures a company's ability to do so without considering inventory as a current asset. Both ratios ideally be above 1:1, with the current ratio ideally between 1.5-2:1. The ratios help creditors and investors evaluate the company's liquidity risk. However, they do not consider qualitative factors and may mislead for companies with different objectives. Examples are provided to demonstrate calculating the ratios.
2. Liquidity Ratio Assets -> cash Quickly and no loss of value reveals the level of liquidity 2 types- Current Ratio/ Acid Test Ratio Comes from the Balance Sheet
3. Key Terms Liquid assets (Current Assets)- Cash, Debtors, Stock Short- term liabilities Working Capital Opportunity Cost Liquidity crisis
4. Current Ratio Liquid assets and short-term liabilities Working capital Formula Current Assets ____________ Current Liabilities
5. Value/ Importance Using liquid assets to cover short-term liabilities Desirable ratio of 1.5-2.0 to 1 Safety margin Shows the liquidity position of the firm Important for trade creditors
6. Acid Test Ratio Current assets and short- term liabilities (working capital)- stock Formula Current Assets- Stock _________________ Current Liabilities
7. Value/ Importance More meaningful than Current Ratio At least 1:1 Important for potential investors and short- term lenders (exposes the level of risk) Can determine 2 things: experiencing a liquidity crisis holding too much current assets
8. Limits of Liquidity Ratios Ratios – (historical account of a firm’s performance) Qualitative factors- ignored Organizational objectives differ between businesses (misleading) Ex. Supermarkets and Jewelry shops
9. Example: Current Ratio Company A Current Assets: 500,000 Stock: 200,000 Cash: 100,000 Debtors: 200,000 Current Liabilities: 350,000 500,000 _________ 350,000 Current Ratio- 1.43:1 Meaning: For every $1 of current liabilities, the firm has $1.43 of current assets
10. Example: Acid Test Ratio Company A Current Assets: 500,000 Stock: 200,000 Cash: 100,000 Debtors: 200,000 Current Liabilities: 350,000 (500,000- 200,000)= 300,000 _______________ 350,000 Acid Test Ratio- 1:1.12 Meaning: For every $1.12 of current liabilities, the firm has $1 of (current assets- stocks) = Possible that the firm is experiencing a LIQUIDITY CRISIS!!
