Liquidity Ratios
Investor look at
liquidity ratios to determine the ability of a business to pay off
its short term obligations from cash or near cash assets to evaluate
the risk associated if were to invest in this company. Failure to
pay off short term obligation may resulted in financial difficulty
or bankruptcy in near future.
Liquidity
ratios help investors to minimize the
risk in stock market investment to screen out financial
sound companies on stock pick to build up their "buy and
hold" portfolio.
Cash Ratio
|
Cash ratio measure the ability of
a business to meet short term obligations. It measures
to the extent which current obligations can be paid from
cash or near cash assets. Cash ratio
= (Cash and Cash equivalents) /
Current Liabilities
|
|
Cash Ratio |
<= 1 |
Dangerous Zone. Very low
liquidity. |
|
1 < |
Cash Ratio |
|
Short term debt can be
paid in full with cash and
near cash items. |
|
2 < |
Cash Ratio |
|
Bad management of short
term liquidity ? Cash
could be invested in
longer term assets earning a
higher return. |
|
Quick Ratio
|
Quick ratio also
known as Liquidity
Ratio or Acid Test, it measures the ability of a company
to pay off its short-term obligations from current
assets, excluding inventories. The reason of excluding
inventories is due to it's low liquidity and thus quick
ratio provide better measurement of company ability to
paid off it current obligations compare to current
ratio. Quick ratio does not apply to companies with
inventory is easily converted into cash, use current
ratio instead. Quick ratio = (Current Assets -
inventory) /
Current Liabilities
|
|
Quick Ratio |
<= 1 |
Dangerous Zone. Very low
liquidity. |
|
1 < |
Quick Ratio |
<= 2 |
May fail to meet short
term commitments |
|
2 < |
Quick Ratio |
<= 5 |
Normal, depending on the
industry standards for
companies of similar size
and activity. |
|
5 < |
Quick Ratio |
|
Very little short term
debt! |
|
Current Ratio
|
Current ratio measures the company's ability to pay
its short-term liabilities from short-term assets.
Current ratio =
Current Assets /
Current
Liabilities
|
|
Current Ratio |
<= 1 |
Going
bankrupt! |
|
1 < |
Current Ratio |
<= 2 |
May
experience difficulties in facing short term
commitments. |
|
2 < |
Current Ratio |
<= 5 |
Normal,
depending on the industry
standards for
companies of similar size and activity. |
|
5 < |
Current Ratio |
Very little
short term debt! |
|
Inventory to Net Working
Capital
|
Inv to NWC =
inventory /
(Current Assets -
Current Liabilities)
|
|
Inv to NWC |
<= 0 |
Going bankrupt! |
|
1 < |
Inv to NWC |
|
Too much dependence on inventory to liquidate
short term debts |
|
Liquidity Ratios