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Saturday, November 13, 2010

Financial Metrics - Liquidity Ratios

Liquidity is a key to an organization's ability to continue business and capitalize on opportunities.  Liquidity ratios are helpful for short term creditors and bankers.  They are also important to financial managers who must meet obligations to suppliers of credit and various government agencies.  A complete liquidity ratio analysis can help uncover weaknesses in the financial position of your business.  The following are key ratios to analyze liquidity:
  • Current Ratio
  • Quick Ratio
  • Absolute Liquidity Ratio
  • Basic Defense Interval
  • Receivable Turnover
  • Average Collection Period
  • Inventory Turnover

Current Ratio - test of the solvency balances your current assets against your current liabilities.  The current ratio will disclose balance sheet changes that net working capital will not.

Current Assets / Current Liabilities = Current Ratio

Quick Ratio - specifies whether your current assets that could be quickly converted into cash are sufficient to cover current liabilities.  A company that has additional sufficient quick assets available to creditors is believed to be in sound financial condition.

( Cash + Marketable Securities + Net Accounts Receivable) / Current Liabilities = Quick Ratio

Absolute Liquidity Ratio - eliminates any unknowns surrounding receivables

( Cash + Marketable Securities ) / Current Liabilities = Absolute Liquidity Ratio

Basic Defense Interval - if revenues suddenly ceased, the Basic Defense Interval would help determine the number of days your company can cover its cash expenses without the aid of additional financing.

( Cash + Receivables + Marketable Securities ) / (( Operating Expenses + Interest + Income Taxes )/365 )

              = Basic Defense Interval

Receivable Turnover - indicates management's efficiency in employing those funds invested in receivables.  Net Credit Sales, while preferable, may be replaced in the formula with net total sales for an industry-wide comparison.

Total Credit Sales / Average Receivables Owing = Receivable Turnover Ratio

Average Collection Period - a test for the quality of your receivables business, giving you the average length of the collection period.

( Accounts + Notes Receivable) / (( Annual Net Credit Sales) / 365) = Average Collection Period

Inventory Turnover - a general rule is to multiply your inventory turnover by your gross margin percentage.  If the result is 100 or greater, your average inventory is not too high.

Cost of Goods Sold / Average Inventory = Inventory Turnover Ratio

A close watch on the liquidity is essential to ensuring the sustained health of the organization.  Adjusting to changing times is essential to the success.

Read more about ratios at:
Financial Metrics - Ratio Analysis Considerations