Liquidity Ratios

Financial reporting, financial statement analysis, and valuation

Liquidity ratios, which focuses on cash flows, measures a company’s ability to meet its short term obligations. Liquidity measures how quickly assets are converted into cash. Liquidity ratios also measure the ability to pay off short-term obligations. In day-to-day operations, liquidity management is typically achieved through efficient use of assets.

Stickney brown wahlen 6th edition 2007 Page 290-291

Current Ratio:

The current ratio equals current assets divided by current liabilities. It indicates the amount of cash available at the balance sheet date plus the amount of other current assets that the firm expects to turn into cash within one year of the balance sheet date.

For example, a debt-to-asset ratio of 0.40 or 40 percent indicates that 40 percent of the company’s assets are financed with debt. Generally, higher debt means higher financial risk and thus weaker solvency.

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Profitability Ratios:

The ability to generate profit on capital invested is a key determinant of a company’s overall value and the value of the securities it issues. Profitability reflects a company’s competitive position in the market, and by extension, the quality of its management. The income statement reveals the sources of earnings and the components of revenue and expenses. Earnings can be distributed to shareholders or reinvested in the company. Reinvested earnings enhance solvency and provide a cushion against short-term problems.

Profitiability ratios measure the return earned by the company during a period.

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Gross profit

So, an operating margin increasing faster than gross margin can indicate improvements in controlling operating costs, such as administrative overheads. In contrast, a declining operating profit margin could be an indicator of deteriorating control over operating costs.

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Valuation Ratios:

Valuation ratios have long been used in investment decision making. A well-known example is the P/E ratio- probably the most widely used indicator in discussing the value of equity securities- which relates share price to the earnings per share (EPS).

The P/E ratio expresses the relationship between the price per share and the amount of earnings attributable to a single share. In other words, the P/E ratio tells us how much an investor in common stock pays per dollar of current earnings.

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Acid-Test ratio:

The Acid-test (quick) ratio is a measure of a company’s immediate short-term liquidity. It is computed by dividing the sum of cash, short-term investments, and net receivables by current