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Demystifying your Accounts - Liquidity Ratios

Written by Rory Noorland, Associate, CooperAitken.

A set of financial accounts can provide far more than a simple report on the profit or loss your business has made. Digging a little deeper and running some relatively simple equations can provide an insight in to the strength and health of your business. There are many tools and measures to assist you in ‘demystifying your accounts’ to convert the information contained in those financial statements into some useful insights into your business.

For the fourth and final article of our series we will look at a how the previous measures (Interest cover, Accounts Receivable and Inventory turnover) tie together so you can assess the liquidity of your business.
 

Liquidity ratio
 

Liquidity ratios are a measure of the ability for you to pay short-term debts with the assets that can be easily converted into cash in the short term. This article will step you through three ratios which can demonstrate your ability to meet your short term debts over three different periods of time, taking in to account the ease in which various current assets can be converted in to cash.   

To calculate the ratios we first need to define a current asset and a current liability.

A current asset is an asset that is cash or can be converted to cash within the next 12 months.  For example, current assets include;

  • Cash & Cash Equivalents
  • Short-Term Investments
  • Accounts Receivable
  • Inventory

A current liability is a liability that needs to be paid within the next 12 months.  A current liability includes;

  • Accounts payable
  • Tax due
  • GST payable
  • Current portion of term loans
  • Credit cards
  • Overdraft

The three calculations are:

Current ratio

Current assets ÷ Current liabilities

Quick ratio

(Cash & Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities

Cash ratio

(Cash & Cash Equivalents + Short-Term Investments) ÷ Current Liabilities

Example

In order to demonstrate the application of the three ratios consider the following scenario:

Current assets                                  
Cheque account                          35,605
Accounts receivable                 115,156

Inventory                                     27,800

Tax refund due                            11,641
Total                                         190,202 

Current liabilities
GST payable                              12,631
Accounts Payable                      93,205
Total                                        105,836

Current Ratio

The current ratio is calculated as Current assets ÷ Current liabilities

                190,202 ÷ 105,836 = 1.80:1. 

This means that for every dollar of current liabilities you have there is $1.80 of current assets to meet it.

Quick Ratio

The quick ratio requires that we exclude inventory as it is not as easily converted into cash. 

The quick ratio is calculated as (Cash & Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities

                (35,605  + 115,156 + 11,641) ÷ 105,836

                162,402 ÷ 105,836 = 1.53:1

Here we can see that for every dollar of current liabilities you have there is $1.53 of assets that can be quickly converted into cash to meet your current liabilities

Cash Ratio

Finally, the cash ratio assesses your ability to meet all of your current liabilities solely from the cash and cash equivalents in your business in the short term.  Note that the tax refund due is considered an accounts receivable for the purposes of this calculation. 

The cash ratio is calculated as (Cash & Cash Equivalents + Short-Term Investments) ÷ Current Liabilities

              $35,605 ÷ $105,836 = 0.34:1

This ratio shows that there is only 34 cents of cash or cash equivalent assets for every dollar of the current liabilities that your business will need to meet within the next 12 months.  Although not all of these liabilities will need to be met immediately it will be necessary to ensure that there is sufficient cash flow to meet them when they do fall due.

It is for this reason that we have previously put focus on the inventory turnover ratio and accounts receivable turnover ratio. The faster that both our inventory and accounts receivable are turned into cash the better that the cash ratio will be, and therefore your business will be in a more favourable position to meet its obligations as they fall due. Whilst each business and industry will have an optimal cash ratio, the important thing is to measure your ratio and understand the implications of the ratios on your business. 

 

For more information please contact Rory Noorland on 07 889 8850   

 

 

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