Saturday, December 4, 2010

Liquidity Ratios




Liquidity refers to the ability of a borrower to pay his debts as and when they fall due. Good liquidity is a requirement of all companies especially banks and other financial institutions. Imagine going to your bank to withdraw cash and the cashier at the counter says, I don't have enough money in the branch come back later. It would be frustrating wouldn't it be? This would not happen if the bank had enough liquidity to meet its daily customer withdrawal needs.

Ok, now coming back to the topic, Liquidity Ratios are the ratios that can be used to measure the liquidity of a company. As a rule of the thumb, all companies must have good liquidity ratios.

The four main ratios that fall under this category are:

1. Current Ratio or Working Capital Ratio
2. Acid-test Ratio or Quick Ratio
3. Cash Ratio
4. Operation Cash-flow ratio

Let us take a look at each of them in detail.

Current Ratio:

The Working Capital Ratio or Current Ratio is a financial ratio that measures whether or not a company has enough cash to pay off all the debt payments that are due over the next 1 year (12 months) It compares the organizations current assets and its current liabilities.

Formula:

WCR = Current Assets / Current Liabilities

Ex: Let us say ABC Corp has total assets of 5 crores and owes State Bank of India a loan of 3 crores to be repaid before the end of next year, the WCR for them would be

WCR = 5,00,00,000/3,00,00,000 = 1.66

This effectively means that, as of today ABC corp has 1.66 rupees for every rupee of debt it owes SBI.

Though this is good, an acceptable WCR in market terms is 2 or greater which shows that the company is sufficiently liquid and financially stable.

Acid Test Ratio:

Acid-test or Quick Ratio measures the ability of a company to use its cash or near cash assets to extinguish or pay-off its current liabilities immediately. Near cash assets are those that can be quickly converted to cash at close to their book values.

Formula:

ATR = (Current Assets – (Inventories + Prepayments)) / Current Liabilities

A company with a quick ratio of less than 1 cannot currently pay-off all its current liabilities. Any good company would want to maintain their acid test ratio to be greater than 1 at all times.

Cash Ratio:

Cash Ratio is a financial ratio that is used to identify the amount of a company’s assets that are maintained as cash or near cash entities. This is extremely important for banks and financial institutions (If you go back to the beginning of this article to the bank – cash withdrawal example, you can now relate the fact that I was in fact talking about this ratio only)

Formula:

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.

Companies strive to maintain a good cash ratio but at the same time try to ensure that they do not hold on to too much cash that is lying idle in their bank accounts.

Operation Cash Flow Ratio:

Operation Cash Flow Ratio is a financial ratio that is used to identify the percentage of money raised by the company as part of the operation cash flow to the total debt the company owes. Operating cash flow is the cash generated from the operations of the organization after excluding taxes, interest paid, investment income etc.

Formula

OCFR = Operation Cash Flow / Total Debts

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