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Friday, May 21, 2010

Liquidity Ratios – Quick Ratio

Companies are not able to convert their entire current asset into cash very quickly. In particular, some manufacturing companies might hold large quantities of few material stocks, which must be used in production to create finished goods stocks. Finished goods stocks might be warehoused for a long time, or sold on lengthy credit. In such businesses, where stock turnover is slow, most stocks are not very “liquid” assets, because the cash cycle is so long. For these reasons, we calculate an additional liquidity ratio, known as the quick ration or acid ratio.

Quick ratio, or acid ratio = (Current assets – stocks) / Current liabilities

This ratio should ideally be at least 1 for companies with a slow stock turnover. For companies with a fast stock turnover, a quick ratio can be comfortably less than 1 without suggesting that the company should be in cash flow trouble.

Both the current ratio and the quick ratio offer an indication of the company’s liquidity position, but the absolute figures should not be interpreted too literally. It is often theorized that an acceptable current ratio is 1.5 and an acceptable quick ratio is 0.8, but these should only be used as a guide.

What is important is the trend of these ratios?

From this, one can easily ascertain whether liquidity is improving or deteriorating. If budges has a traded for the last 10 years (very successfully) with current ratios of 0.52 and quick ratios of 0.17 then it should be supposed that the company can continue in business with those levels of liquidity. If in the following year the current ratio were to fall to 0.38 and the quick ratio to 0.09, then further investigation into the liquidity situation would be appropriate. It is relative position that is far more important that the absolute figures.

Don’t forget the other side of the coin either. A current ratio and a quick ratio can get bigger than they need to be. A company that has large volumes of stocks and debtors might be over-investing in working capital, and so tying up more funds in the business than it needs to. This would suggest poor management of debtors (credit) or stocks by the company.


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