How does the current ratio relate to the other liquidity ratios?

What are 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

What is a liquidity order?

ORDER OF LIQUIDITY is when items on a balance sheet are listed in order of liquidity. After cash, the other current assets are listed in order of liquidity or nearness to cash (i.e. Accounts Receivable first, then Inventory).

Why are liquidity ratios important in bank lending?

Businesses use a variety of performance evaluation measures to analyze the results of their actions. Investors perform a variety of calculations to review the actions of a particular company. Both company management and investors spend time focusing on the company's "liquidity." Liquidity considers the company's ability to pay its current obligations and its cash levels. Certain financial ratios provide important information regarding a company's liquidity.In general, the greater the coverage of liquid assets to short-term liabilities, the more likely it is that a business will be able to pay debts as they become due while still funding ongoing operations. On the other hand, a company with a low liquidity ratio might have difficulty meeting obligations while funding vital ongoing business operations.Liquidity ratios are sometimes requested by banks when they are evaluating a loan application. If you take out a loan, the lender may require you to maintain a certain minimum liquidity ratio, as part of the loan agreement. For that reason, steps to improve your liquidity ratios are sometimes necessary.When analyzing the financial health of a firm there is four different groups of ratios that the analyst will consider. The groups are liquidity ratios, financial leverage ratios, efficiency ratios, and profitability ratios. In analyzing liquidity ratios, how they are defined and who uses them will be discussed. Problems associated with liquidity ratios will be addressed along with adjustments that are to be made to these ratios. Analysts will then be able to make correct assumptions about the liquidity of a firm.The most used liquidity ratios are: ratios concerning receivables, inventory, working capital, current ratio, and acid test ratio. Other ratios related to the liquidity of a firm deal with the liquidity of its receivables and inventory. The ratios indicating the liquidity of a firm's receivables are days' sales in receivables, accounts receivable turnover, and account receivable turnover in days. Days' sales in receivables relate the amount of accounts receivable to the average daily sales on account. This is computed by gross receivables divided by average net sales per year. Short-term creditors will view this as an indication of a firm's liquidity. Internal analysts should compare it to the firm's credit terms to analyze if the firm is managing its receivables efficiently. The days' sales in receivables should be close to the firm's credit terms. Accounts receivable turnover indicates the liquidity of a firm's receivables. This is measured in times per year and is computed by net sales divided by average gross receivables. This figure can also be expressed in days by average gross receivables divided by average net sales for the year. Inventories are a significant asset of most firms; thus they are indicative of a firm's short-term debt paying ability. The liquidity of a firm's inventories can be analyzed through the use of the following ratios: days' sales in inventory, inventory turnover, and inventory turnover in days. In calculating days' sales in inventory the analyst would divide ending inventory by a daily average of cost of goods sold. The result is an estimate of the number of days that it will take for the firm to sell current inventory. Inventory turnover is calculated by cost of good sold divided by average inventory. This forecasts the liquidity of the inventory and is expressed as times per year. This formula can be revised by dividing average inventory by average daily cost of goods sold so that the turnover is expressed in the number of days. Creditors consider low inventory turnover as a liquidity risk associated with the firm. Management uses inventory turnover to utilize effective inventory control. If it is too high the firm may be losing sales due to not enough inventories. If too low there may be a problem with overstocking or obsolescence and the cost associated with carrying such inventory. Working capital is defined as current assets minus current liabilities. Analysts to determine the short-term solvency of a firm calculate this ratio. Management uses this ratio, since some loan agreements or bond indentures contain stipulations concerning minimum working capital requirements. A firm's current ratio is determined by current assets divided by current liabilities. This measures a firm's ability to meet is current liabilities out of its current assets. An average of two to one is usually the norm. A shorter operating cycle will result in a lower current ratio whereas; a longer operating cycle will result in a higher current ratio. The current ratio shows the size of the relationship between current assets and liabilities, enhancing the comparability between firms.The acid test ratio (Quick ratio) is computed by current assets minus inventory divided by current liabilities. Thus this relates the most liquid assets to current liabilities. This is the most stringent test of liquidity. The usual guideline for the ratio is one to one. Short-term creditors will use this as an indication of a firm's ability to satisfy its short- term debt immediately. The management of the firm will have a greater difficulty borrowing short-term funds if the firm has a low quick ratio. If the ratio is very low, it is an indication that the firm will not be able to meet its short-term obligations. When using liquidity ratios the analyst will start with receivables and inventory, if a liquidity problem is suggested further analysis using the current and quick ratio will be used and the analyst will form an opinion accordingly.Analysts use liquidity ratios to make judgments about a firm, but there are limitations to these ratios. The liquidity of a firm's receivables and inventories can be misleading if the firm's sales are seasonal and or the firm uses a natural business year. The analyst would then adjust the figures accordingly to compare with other firms. The valuation method used will have a major impact on the firm's liquidity of its inventory. Valuation of a firm's inventory under the Last-In-First-Out (LIFO) approach will cause an understatement of inventory with will carry over as an understated current ratio. The use of LIFO may cause unrealistic days' sales in inventory and a much higher inventory turnover. The analyst would take the valuation method used into account when comparing with other firms. One way to judge the liquidity of a firm is to use not only traditional liquidity measures but also consider certain cash flow ratios. In doing liquidity analysis cash flow information is more reliable than balance sheet or income statement information. The cash flow ratios that test for solvency and liquidity are: operating cash flow (OCF), funds flow coverage (FFC), cash interest coverage (CIC), and cash debt coverage (COC). Cash flow ratios determine the amount of cash generated over a period of time and compare that to short-term obligations. This gives a clearer picture if the firm has a liquidity problem in connection with its short-term debt paying ability. Operating cash flow is computed by dividing cash flow from operations by current liabilities. This shows the company's ability to generate the resources needed to meet current liabilities. The funds flow coverage ratio is computed by dividing earnings before interest, taxes plus depreciation and amortization (EBITDA) divided by interest plus tax adjusted debt repayment plus tax adjusted preferred dividends. This ratio will help determine if the firm can meet its commitments. A measurement of one from this ratio indicates that the firm can just barley meet its commitments, less than one indicates that borrowing is needed to meet current commitments. The cash interest coverage ratio is computed by the summation of cash flow from operations, interest paid, and taxes paid divided by interest paid. This will help the analyst determine the firm's ability to meet its interest payments. If the firm is highly leveraged it will have a low ratio and a ratio of less than one places serious concerns about a firm's ability to meet its interest payments. The cash debt coverage is calculated by operating cash flow minus cash dividends divided by current debt. This indicates the firm's ability to carry debt comfortably. The higher the ratio the higher the comfort level. All of the cash flow ratios are not uniform but vary by industry characteristics. The analyst would then adjust his assumptions accordingly to assess the liquidity of a firm.Businesses use a variety of performance evaluation measures to analyze the results of their actions. Investors perform a variety of calculations to review the actions of a particular company. Both company management and investors spend time focusing on the company's "liquidity." Liquidity considers the company's ability to pay its current obligations and its cash levels. Certain financial ratios provide important information regarding a company's liquidity.Bill Payment:A primary reason liquidity ratios require attention involve the company's ability to pay its bills. Liquidity ratios compare the current assets of a business to the current liabilities. The current assets represent the resources available for paying bills. Current liabilities represent the bills waiting to be paid. Investors want to see that companies pay their bills without struggling. Creditors want to see that the company holds enough financial resources to meet its current obligations as well as future obligations that may arise from business with the creditor. Future Investments:Businesses consider financial investments, such as purchasing new equipment or new product launches, as they plan their future strategy. Future investments require financial resources to pay for those investments. When a company holds enough liquid resources to fund its strategic plans, it requires no additional financing to pursue those investments. Liquidity ratios provide management with information regarding its financial resources and whether it needs to obtain additional financing. Dividends:Companies often provide a return to stockholders through cash or stock dividends. Cash dividends provide a direct payment to the stockholders. Stock dividends provide stockholders with additional shares of company stock. Companies usually pay stock dividends when they want to compensate the stockholders but lack the cash to make cash dividend payments. Companies use liquidity ratios to determine whether to pay cash dividends or stock dividends to stockholders. The liquidity ratios demonstrate the company's ability to make cash dividend payments. Cash Balance:A company's cash balance serves several purposes. It provides financial resources for the company to pay bills. It maintains a financial safety net for unexpected expenses or a reduction in revenues. And it builds cash pool to allow the company to take advantage of opportunities. The company uses liquidity ratios to determine the level of cash the company currently has and what level of cash it needs to have.

How do you calculate Bank liquidity ratio?

Cash and near cash/Customers deposit and other current liabilities

What are some specific liquidity and solvency ratios that you could use for analysis purposes?

The most basic liquidity ratio is the current ratio, which can be obtained by dividing the current assets by current liabilities* Email Print * del.icio.us * digg * newsVine* * * font sizeFinancial ratios are the nuts and bolts of financial statements. They could be a very handy tool for investors. But they are useful only if you know which nut and bolt fits where. Otherwise, handling so many financial ratios could be painful. A few Illustration: Jayachandran / Mint.weeks ago, our friends Jinny and Johnny talked about one of the most important ratios - the P-E multiples. Now Johnny wants to understand some more ratios: liquidity ratios, turnover ratios, coverage ratios, profitability ratios or any other ratio he can lay his hands on.Jinny: Hi, Johnny! You are looking quiet today. What's the matter?Johnny: I have been looking at financial statements of a few companies but I don't really know how I can compare their strengths and weaknesses.Jinny: Well, financial statements of companies are full of numbers that can tell you a lot about companies' strengths and weaknesses but the problem is that numbers talk with numbers only. So you can make an intelligent analysis only if you know how to establish the relationship between different set of numbers.In this respect, financial ratios are of great help. They provide us relationships between two different sets of numbers. In a nutshell, they can tell us how effectively the company is managing its inventory or how quickly the company is receiving its sales proceeds. To find the right answers, we just need to choose the right ratio.By comparing financial ratios we can very well compare the performance of two different companies or the present performance of the same company with its past performance or with the present performance of the industry as a whole.Johnny: It seems ratios are of great use. Tell me about some key financial ratios.Jinny: There are a lot many ratios, each having its own significance. Today I will tell you about just one of them, so let's start with the liquidity ratios, the favourite of lenders of companies. Liquidity ratios tell us how well placed a company is in meeting its short-term liabilities. The most basic liquidity ratio is the current ratio, which can be obtained by dividing the current assets by current liabilities. This ratio tells us how many times the current assets are worth in terms of the current liabilities. If the current ratio is 2, then it means that the current assets are worth two times the current liabilities. That means the company is in a position to comfortably pay its dues.But, you may ask, what exactly is included in the current assets and liabilities? Well, current assets are assets which can be converted into cash within a short period of time, normally not exceeding one year. It includes many things, such as cash and bank balances, investments in different securities, money receivables, short-term loans and advances, inventory of raw materials as well as stock in progress and finished goods, etc.Current liabilities are short-term obligations which the company has to meet within the next one year. It includes all short-term borrowings repayable within one year, instalments and interests of term loans, deposits maturing within one year, sundry creditors for raw materials, stores and consumable spares, etc. You can find the current assets and liabilities of the company from its balance sheet.Johnny: What other liquidity ratios can be used?Jinny: Well, we can also use the acid test or quick ratio to make a more strict measurement of liquidity. This ratio excludes inventory from the current assets of the companies. This means that only cash and bank balances, investment in different securities and money receivables are treated as current assets. Current liabilities include all the components that I have told you about.Why are inventories excluded? This is done because it is difficult to convert inventories like raw materials or stocks in progress quickly into cash. Even finished goods can be converted into cash only with some time lag. The quick ratio tells us how well placed the company is in quickly meeting its short-term obligations. A company that has a high quick ratio is keeping its chequebook ready and will not ask its lenders to pick up unsold fish curry as repayment of its debt. Good for lenders.But there is yet another ratio, called super acid test or super quick ratio, that measures liquidity in even more strict terms. This ratio treats only cash, bank deposits and investments in different securities as current assets and excludes money receivables from current assets. Money receivables are what others owe us and sometimes it is really difficult to get them back.A company with a high super quick ratio is keeping most of the money in its own pocket. A good sign if the company owes you money, but not a very good sign for the owners of the company. A high super quick ratio means that the company is keeping its cash idle. That's not a very smart way of doing business.Johnny: That's true, Jinny. Sitting on idle cash is like sitting on fire.What:Financial ratios help in analysing the financial statements of companies.Who: Lenders and investors examine liquidity ratios to understand how well a company is placed to meet its short-term liabilities.How: Different liquidity ratios compare different elements of current assets with current liabilities.Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com

What ia a proportion?

A proportion is a relationship between two equal ratios or fractions. It compares corresponding parts of a whole and indicates how they relate to each other. Proportions are often used in math and statistics to solve problems involving ratios, percentages, and percentages.

What is the Importance of liquidity ratio to shareholders?

liquidity ratio's are important to shareholders because in a way the ratio's show them if the business is worth investing in. if a business has bad liquidity ratios because they ant payy off their debts, people are less likely to invest because they have they don't wnat to pay off other people debts. the ratio that shareholders are really interest in is return on capital employed because it shows how the net profit is distributed.

What is management accounting explain ratio analysis in detail?

Financial ratios are useful indicators of a firm's performance and financial situation. Most ratios can be calculated from information provided by the financial statements. Financial ratios can be used to analyze trends and to compare the firm's financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy. Financial ratios can be classified according to the information they provide. The following types of ratios frequently are used: • Liquidity ratios • Asset turnover ratios • Financial leverage ratios • Profitability ratios • Dividend policy ratios Liquidity Ratios Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. They are of particular interest to those extending short-term credit to the firm. Two frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio. The current ratio is the ratio of current assets to current liabilities: Current Ratio = Current Assets Current Liabilities Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm's assets are working to grow the business. Typical values for the current ratio vary by firm and industry. For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns. One drawback of the current ratio is that inventory may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets. The quick ratio is defined as follows: Quick Ratio = Current Assets - Inventory Current Liabilities The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. These assets essentially are current assets less inventory. The quick ratio often is referred to as the acid test. Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets except the most liquid: cash and cash equivalents. The cash ratio is defined as follows: Cash Ratio = Cash + Marketable Securities Current Liabilities The cash ratio is an indication of the firm's ability to pay off its current liabilities if for some reason immediate payment were demanded. Asset Turnover Ratios Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover. Receivables turnover is an indication of how quickly the firm collects its accounts receivables and is defined as follows: Receivables Turnover = Annual Credit Sales Accounts Receivable The receivables turnover often is reported in terms of the number of days that credit sales remain in accounts receivable before they are collected. This number is known as the collection period. It is the accounts receivable balance divided by the average daily credit sales, calculated as follows: Average Collection Period = Accounts Receivable Annual Credit Sales / 365 The collection period also can be written as: Average Collection Period = 365 Receivables Turnover Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time period divided by the average inventory level during that period: Inventory Turnover = Cost of Goods Sold Average Inventory The inventory turnover often is reported as the inventory period, which is the number of days worth of inventory on hand, calculated by dividing the inventory by the average daily cost of goods sold: Inventory Period = Average Inventory Annual Cost of Goods Sold / 365 The inventory period also can be written as: Inventory Period = 365 Inventory Turnover Other asset turnover ratios include fixed asset turnover and total asset turnover. Financial Leverage Ratios Financial leverage ratios provide an indication of the long- term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt. The debt ratio is defined as total debt divided by total assets: Debt Ratio = Total Debt Total Assets The debt-to-equity ratio is total debt divided by total equity: Debt-to-Equity Ratio = Total Debt Total Equity Debt ratios depend on the classification of long-term leases and on the classification of some items as long-term debt or equity. The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows: Interest Coverage = EBIT Interest Charges where EBIT = Earnings Before Interest and Taxes Profitability Ratios Profitability ratios offer several different measures of the success of the firm at generating profits. The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. It is defined as follows: Gross Profit Margin = Sales - Cost of Goods Sold Sales Return on assets is a measure of how effectively the firm's assets are being used to generate profits. It is defined as: Return on Assets = Net Income Total Assets Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm's stock. Return on equity is defined as follows: Return on Equity = Net Income Shareholder Equity

What is a similarity ratio?

similarity ratios are ratios in which both the ratios are equal to each other

Are two ratios always equal to each other?

No but the equal ratios are called Equivalent Ratios.

How do banks identify liquidity risk?

Frequent borrowings from other institutions, Excess of outflows over inflows, negative liquidity gaps.

Are two ratios sometimes equal to each other?

Yes the ratios are sometimes equal to each other.