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Why is the current ratio the most commonly used to measure of short term liquidity?
Wiki User
∙ 10y ago
current ratio represents whether the entity is in a position to service its obligations towards current liability within its holding of current assets. The word current normally represents an year, within which not much changes regarding market sentiments and stability is expected. Hence the ratios is used to asses the liquidity.
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∙ 10y ago
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How do you calculate liquidity ratio?
You have to calculate the Quick ratio and the Current RatioQuick ratio: (cash+accounts receivables+short-term investments)/current liabilitiesCurrent ratio: Current Assets/Current liabilitiesWhoever submitted this did not answer the question fully. I don't know the answer but I see nothing here that says "Liquidity ratio =" or means the same thing. I have no idea what to do with quick ratio and current ratio....================================================================What Does Liquidity Ratios Mean?A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio. Different analysts consider different assets to be relevant in calculating liquidity. Some analysts will calculate only the sum of cash and equivalents divided by current liabilities because they feel that they are the most liquid assets, and would be the most likely to be used to cover short-term debts in an emergency.A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern.From Investopedia.
What is the quick ratio?
The quick (or acid-test) ratio equals current assets minus inventory divided by current liabilities. This ratio is used to evaluate liquidity and is often used in conjunction with the current ratio. The difference between the current ratio and the quick ratio tells you how much inventory may be tied up in current assets. Relatively large inventories are often a sign of short-term trouble.
What is the meaning of liquidity ratio?
It is the amount which a bank has to maintain in the form of cash, gold or approved securities. it is presently 25%.
How many types of ratio?
Generally, there are 4 types of finance ratios, (if thats what you want). (A) LIQUIDITY RATIO (B) LONG TERM SOLVENCY AND STABILITY RATIO (C) PROFITABILITY & EFFICENCY RATIOS (D) INVESTORS OR STOCK MARKET RATIOS.
How can goal congruEnce for managers and shareholders be achieved?
goals of managers with the goals of shareholders 40 Business Finance Lecture 8 Review of the Previous Lecture 􀂄 Cash Flow Statement 􀂄 Financial Statements Analysis 􀂄 Significance 􀂄 Common Size Analysis Topics under Discussion 􀂄 Financial Statements Analysis 􀂄 Common Size Analysis (Cont.) 􀂄 Ratio Analysis 􀂄 Short-term solvency, or liquidity, ratios 􀂃 Current Ratio 􀂃 Acid Test (Quick) ratio 􀂃 Cash ratio Common-Size Statements 􀂄 One very common and useful way of standardized comparison is to work with percentages instead of dollars. 􀂄 So, a standardized financial statement presenting all items in percentages is called a commonsize statement. 􀂄 Balance sheet items are shown as a percentage of total assets and income statement items as a percentage of sales. A2Z Inc., Balance Sheet A2Z Inc. Balance Sheet as of December 31 ($ in millions) Assets 20X1 20X2 Current Assets Cash $ 84 $ 98 Accounts receivable 165 188 Inventory 393 422 Total $ 642 $708 Fixed assets Net plant and equipment 2,731 2,880 Total assets $3,373 $3,588 A2Z Inc., Balance Sheet Liabilities and equity 20X1 20X2 Current liabilities Accounts Payable $ 312 $ 344 Notes payable 231 196 Total $ 543 $ 540 41 Long-term debt 531 457 Stockholders' equity Common stock and paid-in surplus 500 550 Retained earnings 1,799 2,041 Total $2,299 $2,591 Total liabilities and equity $3,373 $3,588 A2Z Inc., Common-Size Balance Sheet Assets 20X1 20X2 Current Assets Cash 2.5% 2.7% Accounts receivable 4.9 5.2 Inventory 11.7 11.8 Total 19.1% 19.7% Fixed assets Net plant and equipment 80.9% 80.3% Total assets 100.0% 100.0% A2Z Inc., Common-Size Balance Sheet Liabilities and equity 20X1 20X2 Current liabilities Accounts payable 9.2% 9.6% Notes payable 6.8 5.5 Total 16.0% 15.1% Long-term debt 15.7% 12.7% Stockholders' equity Common stock and paid-in surplus 14.8% 15.3% Retained earnings 53.3 56.9 Total 68.1 72.2 Total liabilities and equity 100.0% 100.0% A2Z Inc., Common-Size Balance Sheet More on Standardized Statements Suppose we ask: "What happened to A2Z's net plant and equipment (NP&E) over the period?" 􀂄 Based on the 20X1 and 20X2 B/S, NP&E rose from $2,731 to $2,880, so NP&E rose by $149. 􀂄 Did the firm's NP&E go up or down? Obviously, it went up, but so did total assets. In fact, looking at the standardized statements, NP&E went from 80.9% of total assets to 80.3% of total assets. A2Z Inc., Common-Size Balance Sheet More on Standardized Statements 􀂄 If we standardized the 20X2 numbers by dividing each by the 20X1 number, we get a common base year statement. In this case, $2,880 / $2,731 = 1.0545, so NP&E rose by 5.45% over this period. 42 􀂄 If we standardized the 20X2 common size numbers by dividing each by the 20X1 common size number, we get a combined common size, common base year statement. In this case, 80.3%/ 80.9% = 99.26%, so NP&E almost remained the same as a percentage of assets. (. .) In absolute terms, NP&E is up by $149 or 5.45%, but relative to total assets, NP&E fell by 2.6%. A2Z Inc., Common-Size Balance Sheet More on Standardized Statements 􀂄 Current assets rose from 19.1% in 20X1 to 19.7% in 20X2 􀂄 Current liabilities declined from 16.0% to 15.1% of total liabilities and equity over the same time. 􀂄 Total equity rose from 68.1% of total liabilities and equity to 72.2%. 􀂄 Overall, A2Z's liquidity as measured by current assets compared to current liabilities, increased over the year. Also, A2Z's indebtness diminished as a percentage of total assets. 􀂄 So we may conclude that balance sheet as grown stronger A2Z Inc., Income Statement For the Year 20X2 ($ in millions) Net sales $2,311 Cost of goods sold 1,344 Depreciation 276 Earnings before interest and taxes $ 691 Interest 141 Taxable income 550 Taxes 187 Net income $ 363 Dividends $121 Retained earnings 242 A2Z Inc., Common-Size Income Statement Net sales 100.0 % Cost of goods sold 58.2 Depreciation 11.9 Earnings before interest and taxes 29.9 Interest 6.1 Taxable income 23.8 Taxes 8.1 Net income 15.7 % Dividends 5.2% Retained earnings 10.5 A2Z Inc., Common-Size Income Statement 􀂄 This statement tells us what happened to each dollar in sales. 􀂄 For A2Z interest expense eats up 6.1% of sales, while taxes take another 8.1% of sales figure. 􀂄 Following this, 15.7% of revenues from sales flow down to bottom as net income; one-third of which is paid in dividends and remainder two-thirds is taken as retained earnings for busniess. 􀂄 As far as cost is concerned, 58.2% of revenues are spent on the goods sold 43 Standardized Financial Statements 􀂄 Although an organization's common-size statements provide a better analytical insight into the it's strength and standing, yet it's performance and efficiency can be better judged by comparing these with those of the firm's competitors. Ratio Analysis 􀂄 Another way of avoiding the problems involved in comparing companies of different sizes, is to calculate and compare financial ratios. 􀂄 One problem with ratios is that different people and different sources frequently don't compute them in exactly the same way. 􀂄 While using ratios as a tool for analysis, you should be careful to document how you calculate each one, and, if you are comparing your numbers to those of another source, be sure you know how their numbers are computed. Ratio Analysis 􀂄 For each of the ratios we discuss, several questions come to mind: 􀂄 How is it computed? 􀂄 What is it intended to measure, and why might we be interested? 􀂄 What is the unit of measurement? 􀂄 What might a high or low value be telling? How might such values be misleading? 􀂄 How could this measure be improved? Ratio Analysis 􀂄 Financial ratios are traditionally grouped into the following categories: 􀂄 Short-term solvency, or liquidity, ratios 􀂄 Ability to pay bills in the short-run 􀂄 Long-term solvency, or financial leverage, ratios 􀂄 Ability to meet long-term obligations 􀂄 Asset management, or turnover, ratios 􀂄 Intensity and efficiency of asset use 􀂄 Profitability ratios 􀂄 Ability to control expenses 􀂄 Market value ratios 􀂄 Going beyond financial statements Short-Term Solvency, or Liquidity Measures 􀂄 The primary concern to which these ratios relate, is the firm's ability to pay its bills over the short run without undue stress. So these ratios focus on current assets and current liabilities. 􀂄 Liquidity ratios are particularly interesting to short-term creditors. Since financial managers are constantly working with banks and other short-term lenders, an understanding of these ratios is essential 44 Short-Term Solvency, or Liquidity Measures 􀂄 Current assets and liabilities 􀂄 Their book values and market values are likely to be similar. 􀂄 They can and do change fairly rapidly, hence unpredictable Current Ratio Current Assets Current Ratio= ------------------------ Current Liabilities 􀂄 Because current assets and liabilities are converted into cash over the following 12 months, the current ratio is a measure of short run liquidity. 􀂄 The unit of measurement is either dollars or times. Current Ratio 􀂄 For A2Z Corporation, the 20X2 current ratio is $708 Current Ratio= ---------- = 1.31 times $540 􀂄 We can say that 􀂄 A2Z has a $1.31 in current assets for every $1 in current liabilities OR 􀂄 A2Z has its current liabilities covered 1.31 times over. Current Ratio 􀂄 To a creditor (particularly a short-term creditor like supplier), the higher the current ratio, the better 􀂄 To firm, high current ratio indicates liquidity, but it may also indicate an inefficient use of cash and other short-term assets. 􀂄 We would expect to see a current ratio of at least 1, because a current ratio of less than 1 would mean that net working capital is negative Current Ratio 􀂄 Like any other ratio, current ratio is effected by various transactions. 􀂄 If a firm borrows over long-term, 􀂄 The short run effect would be an increase in cash as well as in long term liabilities. 􀂄 Current liabilities would not be affected, so the current ratio would rise. 􀂄 An apparently low current ratio may not be a bad sign for a company with a large reserve of unlimited borrowing power. 45 Current Ratio Current Events 􀂄 A firm wants to payoff some of its suppliers and creditors. What would happen to current ratio? 􀂄 Current ratio moves away from 1. if it is greater than 1 it will get bigger. But if it is less than 1, it will get smaller. 􀂄 Suppose a firm has $4 in current assets and $2 in current liabilities for a current ratio of 2. and uses $1 in cash to reduce current liabilities, then new current ratio is ($4-2) / ($2-1) = 3 􀂄 Reversing the situation to $2 in current assets and $4 in current liabilities, the change will cause current ratio to fall to 1/3 from 1/2 Current Ratio Current Events 􀂄 Suppose a firm buys some inventory. What would happen in this case? 􀂄 Nothing happens to current ratio. Because in this scenario, one current asset (cash) goes down while another current asset (inventory) goes up. Total current assets are unaffected. Current Ratio Current Events 􀂄 What happens if a firm sells some merchandise? 􀂄 Current ratio would usually rise because inventory is shown at cost and sale would normally be at something greater than cost (difference is markup). 􀂄 So, the increase in either cash or receivables is greater than the decrease in inventory. 􀂄 This increases current assets and current ratio rises. Quick (or Acid-Test) Ratio 􀂄 Inventory is often the least liquid current asset. And its book values are least reliable as measures of market value since the quality of inventory isn't considered. Some of the inventory may turn out to be damaged, obsolete or lost. 􀂄 Relatively large inventories are often a sign of short-term trouble. 􀂄 The firm may have overestimated sales and overbought or overproduced as a result, hence tied up a substantial portion of its liquidity in slow moving inventory Quick (or Acid-Test) Ratio 􀂄 It is computed just like current ratio, except inventory is omitted. Current Assets - Inventory Quick Ratio= ------------------------------------ Current Liabilities 􀂄 For A2Z, this ratio in 20X2 was $708 - 422 Quick Ratio= ----------------- = 0.53 times $540 46 Quick (or Acid-Test) Ratio 􀂄 The quick ratio here tells a somewhat different story than the current ratio, because inventory accounts for more than half of A2Z's current assets 􀂄 If the same figure is for an aircraft manufacturing corporation, then this would certainly be a cause for a BIG concern. Cash Ratio 􀂄 A very short-term creditor may be interested in the cash ratio Cash Cash Ratio= ----------------------- Current Liabilities 􀂄 Current ratio for A2Z in 20X2 was 0.18 Summary 􀂄 Financial Statements Analysis 􀂄 Common Size Analysis (Cont.) 􀂄 Ratio Analysis 􀂄 Short-term solvency, or liquidity, ratios 􀂃 Current Ratio 􀂃 Acid Test (Quick) ratio 􀂃 Cash ratio Upcoming topics 􀂄 Ratio Analysis (cont.) 􀂄 Long Term Solvency, or Liquidity ratios 􀂄 Asset management, or turnover, ratios 􀂄 Profitability ratios 􀂄 Market value ratios
What is a measure of liquidity?
the two ratios that measure liquidity is acid test and current ratio. the acid test ratio is current assets- stock/ current liabilities the current ratio is current assets/ current liabilities
Current ratio and liquidity ratio are same?
no they are not the same. the current ratio is current assets/current liabilities. but liquidity ratio or acid test ratio is current assets - stock/current liabilities. liquidity ratio shows you how able a business is to pay off its debt when stock is taken out of the equation.
An example of liquidity ratio is the?
current ratio and acid test ratio are examples of liquidity ratios'. current ratio is current asset's/ current liabilities. acid test ratio is current assets- stock / current liabilities.
What are some types of liquidity ratios?
current and quick ratios. The quick (acid test) ratio is a more accurate measure of liquidity because it excludes inventories.
What is current Statutory Liquidity Ratio?
25%
What are the ratios in liquidity?
liquidity ratios include current ratio (which is current assets/current liabilities) and acid test (which is current assets- stock/current liabilities.) liquidity ratio's shows how good a business is a paying off its debts. hope this helps.
Would you expect net income to be a good measure of a company's liquidity?
Generally I would not use Net Income as a measure of liquidity. Net Income is a good measure of profitability, but it does not indicate a company's ability to meet short-term obligations. Some good measures of liquidity include working capital, the current ratio, and the quick ratio.
what is liquidity ratio analysis?
it is an analysis of liquidity of a company. a company that is liquid has surplus cash remaining even after it has fulfilled its obligations. in simple terms, a company which has cash after paying off liabilities is said to have good liquidity.
What is the purpose of the liquidity ratio?
Liquidity ratios measure the availability of cash to pay debt
What is the financial ratio used to assess a company's liquidity?
The quick ratio which equals total assets/total liabilities Answer: 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
Current ratio would normally increased by?
The current ratio is an accounting measure of liquidity and is defined by: Current Assets / Current Liabilities In order to increase the current ratio, either increase current assets (e.g. cash, inventory, accounts receivable) or to decrease current liabilities (e.g. accounts payable, notes payable).
Is quick ratio a better measure of the firms liquidity than current ratio?
Yes because a quick ratio doesn't include inventory which must be sold before it can be used to pay for the companies current obligations. Of course you have to collect the cash in A/R before it can be used to pay for current obligations too but AR should be able to be converted to Cash much quicker than Inventory. A Cash Ratios, which doesn't include AR or Inventory is an even better measure of a firms liquidity than both the quick and current ratio.
