We at Investorwhiz we want you to be an intelligent, well-informed investor who likes to go beyond what those brokers are handing out day in, day out. This time, we are taking you on yet another short tutorial on liquidity ratios that will expand your knowledge and understanding of those numbers on Balance- Sheet.
Workings of Working Capital
To appreciate the significance of liquidity ratios, we first need to understand the concept of working Capital, Current Assets and Current liabilities. An entity’s Current Assets are the assets that can be converted into cash within an operating cycle i.e. usually a year. Likewise, Current liabilities are those financial commitments that become due for payment within a year. Working capital is simply the excess of Current Assets over Current Liabilities which can be shown as below:
Working Capital = Current Assets – Current liabilities
Current Assets refer to those assets that can be liquidated within one year from the day they were created and include:
> Cash and cash equivalents like bank accounts and deposits
> Stocks and inventories
> Prepaid expenses
> Sundry trade debtors and accounts receivables
> Other investments with less than one year term
Current Liabilities are those liabilities that need to be met within one year from the day they appeared in the balance-sheet and include:
> Trade creditors and accounts payable
> Short term debt
> Outstanding expenses and unpaid utility bills
> Other debt that is payable within one year from the date of its creation.
Logic behind the Formula
A positive working capital means that an entity has enough funds to meet its current liabilities without resorting to additional credit line or raising funds. This ratio depicts the financial health of an entity and its ability to carry out its operations without overbearing financial constraints.
On the course to understanding the ratios, we will also explain why excessive liquidity is not a healthy sign and discuss the limiting factors of these ratios. We must mention here that sometimes negative working capital is also a good thing to have. When? Read here.
Current Ratio is the simplest and the most used amongst the list of liquidity ratios. It is also known as working capital ratio and is stated as below:
Current Ratio= Current Assets/ Current Liabilities
As is evident from our earlier discussion that a ratio above one indicates that the entity is able to service its short-term liabilities whereas a ratio under one would talk of “money troubles” within the entity. With a complete analysis, one can also associate the issue of working capital shortages to operational inefficiencies and imprudent financial planning of an entity. In short, this ratio is a gateway that gives a sneak peek into other issues.
Higher the ratio, better it is. It is desirable for this ratio to be greater than 1. It needs to be remembered that current ratio can be >1 mainly because of high Inventories or receivables. Though both signify the amount of cash the company will eventually release, it is not necessarily true, especially during hard times. Similarly, a high amount of payables may lower the ratio but that may not necessarily be bad for the company. Many companies have long payable days i.e manage to pay their suppliers much later than they get money from their buyers thereby improving their liquidity position. Auto companies, FMCG companies fall into this category.
Acid Test Ratio
Acid test ratio is also known as quick ratio and it essentially takes the current ratio a notch higher by taking only “highly” liquid assets in consideration. So what does highly liquid comprise of? Well, highly liquid assets are those assets that are readily convertible into cash without substantial losses and thus it excludes stocks and prepaid expenses. An acid test ratio is depicted in the formula below:
Acid Test ratio = (Current Assets- Stock- prepaid expenses)/ Current Liabilities
If Acid Test Ratio is above one, it shows an excellent liquidity profile of an entity where it can very comfortably meet its commitment on current liabilities. However, we strongly advise looking at current Ratio along with this ratio as well. Why? Read on…..
This one is a further refinement of Acid Test ratio and as you can readily guess from the name, Cash ratio only considers Cash and cash equivalents that include savings in bank and immediately redeemable deposits for gauging the liquidity of an entity. Following is how a cash ratio is calculated:
Cash Ratio = Cash + Cash equivalents / Current liabilities
It is a very narrow ratio and is seldom used for analysis unless except in service industry which has low investment in fixed infrastructure and does not need many credit lines to run operations.
Factors to consider when considering Liquidity indices
1. Just like other ratios, these ratios can be generalised only according to the industry and sector an entity is operating in. Some entities by nature have higher liquidity and some low;
2. Now to answer the question of why high current ratio which means high level of liquidity is not always a good news- because it means underutilisation of resources and money;
3. Liquidity measures can be vastly affected by the recent sale, purchase or construction of an asset. Similarly pre-closure of loan or liquidation of a big liability owing to strategic decisions puts a pressure on the immediate liquidity of a company. So consider these factors before blindly relying on these ratios;
4. Change in trade terms, seasonal nature of goods sold also has a strong bearing on liquidity position.