Peer Comparison of Company’s Liquidity

A company’s liquidity determines its creditworthiness and capacity to borrow at cheaper rates and with better credit conditions, increasing its flexibility.

The less liquid it is, the more likely a corporation is to go bankrupt. Similarly, the less liquid a corporation is, the more likely it is to slide into financial difficulties. The primary indicator of a company’s solvency is its cash flows since it must settle debt obligations with cash.

The liquidity of a corporation may be evaluated using the following financial ratios:

Liquidity Ratios

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

Common liquidity ratios include:

$$\begin{align} \text{Current ratio}&=\cfrac{ \text{Current assets} }{\text{Current liabilities}}\\ \text{Quick ratio}&=\cfrac{ \text{Cash & cash equivalents} +\text{Short-term investments} +\text{Account receivable} }{\text{Current liabilities}}\\ \text{Cash ratio}&=\cfrac{ \text{Cash+Short-term marketable instruments} }{\text{Current liabilities}}\end{align} $$

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

 Activity Ratios

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

$$ \text{Inventory Turnover} =\cfrac{ \text{Cost of goods sold} }{\text{Average inventory}}$$

The number of days of receivables ratio indicates how well a company manages the extension and collection of credit it gives its customers.

$$\text{Number of days of receivables (Days sales outstanding)}=\frac{\text{Average accounts receivable}}{\text{Average day’s sales on credit}}=\frac{\text{Average accounts receivable}}{\text{Sales on credit / 365}}$$

The number of days of inventory ratio indicates the average length of time that inventory remains with a company during its financial year.

$$\text{Number of days of inventory(Days of inventory outstanding)}= \frac{\text{Average inventory}}{\text{Avarage day’s cost of goods sold}}=\frac{\text{Average inventory}}{\text{Cost of goods sold / 365}}$$

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

$$\text{Number of days of payables(Days of payable outstanding)}= \frac{\text{Average accounts payable}}{\text{Avarage day’s Purchases}}=\frac{\text{Average accounts payable}}{\text{Purchases/ 365}}$$

$$\text{Cash conversion cycle = Days of inventory + Days of receivables – Days of payables}$$

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

Question

The following table gives information for companies ABC and XYZ:

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

The current ratio for each company is closest to:

1. Company ABC: 0.88; Company XYZ: 0.56.
2. Company ABC: 0.56; Company XYZ: 0.88.
3. Company ABC: 1.14; Company XYZ: 1.78.

Solution

The correct answer is A.

Company ABC’s current ratio = \(\frac{$10,500,000}{$12,000,000} = 0.875\).

Company XYZ’s current ratio = \(\frac{$4,500,000}{$8,000,000} = 0.5625\).