Knowledge Paper - Internal Liquidity Ratios

Internal Liquidity Ratios

1. Current Ratio

This ratio is a measure of the ability of a firm to meet its short-term obligations. In general, a ratio of 2 to 3 is usually considered good. Too small a ratio indicates that there is some potential difficulty in covering obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them.

Current ratio = current assets / current liabilities

2. Quick Ratio

The quick (or acid-test) ratio is a more stringent measure of liquidity. Only liquid assets are taken into account. Inventory and other assets are excluded, as they may be difficult to dispose of.

Quick ratio = (cash+ marketable securities + accounts receivables)

current liabilities

3. Cash Ratio

The cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current obligations.

Cash ratio = (cash + marketable securities)/current liabilities

4. Cash Flow from Operations Ratio

Poor receivables or inventory-turnover limits can dilute the information provided by the current and quick ratios. This ratio provides a better indicator of a company's ability to pay its short-term liabilities with the cash it produces from current operations.

Cash flow from operations ratio = cash flow from operations

current liability

5. Receivable Turnover Ratio

This ratio provides an indicator of the effectiveness of a company's credit policy. The high receivable turnover will indicate that the company collects its dues from its customers quickly. If this ratio is too high compared to the industry, this may indicate that the company does not offer its clients a long enough credit facility, and as a result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers, and may be a sign that sales are perhaps overstated.

Receivable turnover = net annual sales / average receivables

Where:

Average receivables = (previously reported account receivable + current account receivables)/2