###### Beta and Cost of Capital of a Project

When estimating the cost of equity using the Capital Asset Pricing Model (CAPM),... **Read More**

A company’s liquidity is measured by the extent to which it has current assets, i.e., cash, marketable securities, accounts receivable and inventory which can be readily used to satisfy its short-term obligations.

Liquidity ratios assist in measuring the ability of a company to satisfy short-term obligations when they fall due. A comparison of a company’s liquidity ratios with those of peer companies in the same industry can determine the relative creditworthiness of the company compared to other companies.

Two of the most popular liquidity ratios are the current ratio and the quick ratio:

$$ \text{Current ratio}=\cfrac{ \text{Current assets} }{\text{Current liabilities}} $$

$$ \text{Quick ratio}=\cfrac{ \text{Cash & Cash Equivalents} +\text{Short-term investments} +\text{Account receivable} }{\text{Current liabilities}} $$

The quick ratio excludes inventory because inventory is the least liquid current asset.

The greater the value of a company’s current ratio or quick ratio the greater its level of liquidity.

In addition to liquidity ratios we also have turnover ratios which help to measure how well a company’s current assets are managed over time. These include the accounts receivable turnover and inventory turnover ratios. The accounts receivable turnover ratio measures the average number of times that accounts receivables are created from credit sales and collected during a year.

$$ \text{Accounts receivable turnover}=\cfrac {\text{Credit sales}}{\text{Average receivables}} $$

The inventory turnover ratio measures the average number of times that new inventory is obtained and sold during a year.

$$ \text{Inventory turnover}=\cfrac{\text{cost of goods sold}}{\text{average inventory}} $$

Another useful ratio is the number of days of receivables ratio which indicates how well a company manages the extension and collection of credit which it gives to its customers.

$$ \text{Number of days of receivables}=\cfrac{\text{Accounts receivable}}{\text{average day’s sales on credit}}=\cfrac{\text{Accounts receivable}}{\text{sales on credit}/365} $$

Yet another useful ratio is the number of days of inventory ratio which indicates the average length of time that inventory remains with a company during its financial year.

$$ \text{Number of days of inventory}=\cfrac{\text{Inventory}}{\text{average day’s cost of goods sold}}=\cfrac{\text{Inventory}}{\text{cost of goods sold}/365} $$

The number of days of payables is another ratio which tells us how long it takes the company to pay its own suppliers.

$$ \text{number of days of payables}=\cfrac{\text{Accounts payable}}{\text{Average day’s purchases}}=\cfrac{\text{Accounts payable}}{\text{purchases}/365} $$

Ratios are best utilized when a company can compare values of its ratios over time and also compare these values with those of its peer group. The peer group includes competitors from the same industry and other companies of comparable size.

QuestionThe following table gives information for companies ABC and XYZ:

$$ \begin{array}{c|c|c} {} & {\textbf{Company ABC}} & {\textbf{Company XYZ}} \\ \hline { \text{Current assets }($)} & {10,500,000} & {4,500,000} \\ \hline { \text{Current liabilities }($)} & {12,000,000} & {8,000,000} \\ \end{array} $$

What is the current ratio for each company?

A. Company ABC: 0.88; Company XYZ: 0.56

B. Company ABC: 0.56; Company XYZ: 0.88

C. Company ABC: 1.14; Company XYZ: 1.78

SolutionThe correct answer is A.

Company ABC’s current ratio = $10,500,000/$12,000,000 = 0.875 Company XYZ’s current ratio = $4,500,000/$8,000,000 = 0.5625

*Reading 35 LOS 35b:*

*Compare a company’s liquidity measures with those of peer companies*