Using Liquidity Ratios & Formulas in Financial Analysis

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  • 0:03 What Is Liquidity?
  • 0:54 Current Ratio
  • 2:28 Quick Ratio
  • 3:09 Operating Cash Ratio
  • 4:30 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define liquidity and discuss three financial ratios to determine a company's liquidity: current, quick and operating cash. You'll also learn how to calculate and analyze the ratios.

What Is Liquidity?

ABC Corporation recently bid on a large government contract. The job will require a $100,000 cash outlay to purchase materials, liability insurance, and to buy equipment. In the event that ABC Corp wins the bid, Jeff the owner, knows they will need a loan for this initial cash outlay. He completes a loan application on behalf of the ABC Corp. Upon review of the application, Rachael, the loan officer, explains the loan was not approved due to the lack of liquidity.

Liquidity is the ability to pay off short term debt obligations with the liquidation, or selling, of assets. Assets are items ABC Corporation owns such as inventory, buildings, company trucks, and cars. Jeff asks to meet with the loan officer to better understand this concept of liquidity.

Current Ratio

Rachael starts by explaining ABC's balance sheet. The balance sheet presents a company's assets, or items they own, and liabilities, or obligations they owe. The difference between assets and liabilities is the net worth of the company. Assets are separated on the balance sheet into current and long term. Current assets can be sold, consumed, and used in less than a year. Long terms assets will be held for more than a year.

Jeff admits the company's balance sheet assets are not separated between current and long term, and asks Rachael to distinguish between the two. Rachael shows Jeff the following assets are current: cash, inventory, and accounts receivables, while long term assets are the buildings and company trucks and cars.

Rachael tells Jeff that one of the main ratios the bank utilized to determine ABC's liquidity was the current ratio. The current ratio shows ABC's ability to pay their current liabilities with their current assets. The formula for calculating the current ratio is: current assets / current liabilities.

ABC's current ratio was .2. While it's important to compare ratios to an industry average or a prior period, the current ratio is also called a baseline ratio, which means there's a minimum acceptable standard of 1. Thus, a current ratio less than 1, like ABC's ratio of .2, signifies the company may struggle to pay their current liabilities with their current assets. Now, let's move on to the quick ratio.

Quick Ratio

The quick ratio, also called the acid test ratio, calculates ABC's ability to pay their current liabilities using their current assets minus inventory. This formula can be written as: current assets - inventory / current liabilities.

Rachel explains inventory is deducted because it's the least liquid of current assets and distorts liquidity. Problems with inventory include: obsolescence, changes in consumer taste, alternatives, and seasonality. ABC's quick ratio was less than .15, which indicates their current ratio was skewed by inventory and its potential liquidity issues.

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