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Ratio Analysis
Analysis of Liquidity Ratios
  General Explanation

An analysis of liquidity is concerned with a company's ability to meet its short-term liabilities. Liquidity ratios measure whether assets are readily convertible into cash. All other ratios and measurements of profitability are meaningless if a company cannot pay current debts as they become due. Creditors view a lack of liquidity as an indication that the collection of obligations will be delayed. Management views a lack of liquidity as limiting the freedom of choice in business management. Some of the liquidity ratios are defined below:

  Liquidity Ratios  

Current Ratio

The current ratio measures how many times current assets cover current liabilities. Higher ratios indicate a higher margin of safety for creditors.

Quick Ratio

This ratio eliminates inventory from current assets and measures the relationship of cash, marketable securities and accounts receivable to total current liabilities. Since inventory generally turns over more slowly than accounts receivable, the quick ratio is a measurement of assets with readily available liquidity.

Cash to Current Assets

This ratio provides a measurement of the liquidity of current assets by comparing the relationship between cash and all other current assets.

Cash to Current Liabilities

The comparison of cash to current liabilities indicates the relationship of cash to the obligations which are coming due during the company's operating cycle.

Working Capital

Working capital represents the absolute dollar difference between current assets and current liabilities. Working capital is needed to finance new business ventures or provide for company growth.
Accounts Receivable Turnover The accounts receivable turnover ratio measures how many times the accounts receivable are generated and collected during the current year. Changes in turnover ratios reflect changes in collection policies and changes in the financial health of customers.
Inventory Turnover The inventory turnover ratio measures the number of times a company replaces its inventory during the year. Changes in turnover indicate changes in the types and quality of inventory.
Liquidity Index Current assets are assets which will be turned into cash during the operating cycle of the company. Since some current assets are more readily convertible into cash than others, a liquidity index attempts to measure the relative quality of current assets. A higher number indicates more days removed from cash and less liquidity.


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