Financial Ratio Analysis: Liquidity Ratios

Liquidity Ratios

Liquidity ratios measure the firm's ability to pay its short-term debts as they come due. These ratios are of special interest to the firm's creditors. The three main measures of liquidity are the current ratio, the acid-test (quick) ratio, and net working capital.

The current ratio is the ratio of total current assets to total current liabilities. Traditionally, a current ratio of 2 ($2 of current assets for every $1 of current liabilities) has been considered good. Whether it is sufficient depends on the industry in which the firm operates. Public utilities, which have a very steady cash flow, operate quite well with a current ratio well below 2. A current ratio of 2 might not be adequate for manufacturers and merchandisers that carry high inventories and have lots of receivables. The current ratio for Delicious Desserts for 2018, as shown in Table 14.4, is 1.4. This means little without a basis for comparison. If the analyst found that the industry average for small bakeries was 2.4, Delicious Desserts would appear to have low liquidity.

The acid-test (quick) ratio is like the current ratio except that it excludes inventory, which is the least-liquid current asset. The acid-test ratio is used to measure the firm's ability to pay its current liabilities without selling inventory. The name acid-test implies that this ratio is a crucial test of the firm's liquidity. An acid-test ratio of at least 1 is preferred. But again, what is an acceptable value varies by industry. The acid-test ratio is a good measure of liquidity when inventory cannot easily be converted to cash (for instance, if it consists of very specialized goods with a limited market). If inventory is liquid, the current ratio is better. Delicious Desserts' acid-test ratio for 2018 is 1.1. Because the bakery's products are perishable, it does not carry large inventories. Thus, the values of its acid-test and current ratios are fairly close. At a manufacturing company, however, inventory typically makes up a large portion of current assets, so the acid-test ratio will be lower than the current ratio.

Ratio Analysis for Delicious Desserts at Year-End 2018
Ratio	Formula	Calculation	Result
Liquidity Ratios
Current ratio	$\dfrac{\text{Total current assets}}{\text{Total current liabilities}}$	$\dfrac{$83,200}{$60,150}$	1.4
Acid-test (quick) ratio	$\dfrac{\text{Total current assets–inventory}}{\text{Total current liabilities}}$	$\dfrac{$83,200−$15,000}{$60,150}$	1.1
Net working capital	$\text{Total current assets–Total current liabilities}$	$$83,200−$60,150$	$23,050
Profitability Ratios
Net profit margin	$\dfrac{\text{Net profit}}{\text{Net sales}}$	$\dfrac{$32,175}{$270,500}$	11.9%
Return on equity	$\dfrac{\text{Net profit}}{\text{Total owners' equity}}$	$\dfrac{$32,175}{$78,750}$	40.9%
Earnings per share	$\dfrac{\text{Net profit}}{\text{Number of shares of common stock outstanding}}$	$\dfrac{$32,175}{10,000}$	$3.22
Activity Ratio
Inventory turnover	$\dfrac{\text{Cost of goods sold}}{\text{Average inventory}}$
	$\dfrac{\text{Cost of goods sold}}{\text{(Beginning inventory+Ending inventory)/2}}$	$\dfrac{$112,500}{($18,000+$15,000)/2}$
		$\dfrac{$112,500}{$16,500}$	6.8 times
Debt Ratio
Debt-to-equity ratio	$\dfrac{\text{Total liabilities}}{\text{Owners' equity}}$	$\dfrac{$70,150}{$78,750}$	89.1%

Table 14.4

Net working capital, though not really a ratio, is often used to measure a firm's overall liquidity. It is calculated by subtracting total current liabilities from total current assets. Delicious Desserts' net working capital for 2018 is $23,050. Comparisons of net working capital over time often help in assessing a firm's liquidity.