Study: Liquidity Ratios: Quick Ratio, Working Capital, Cash Conversion Cycle
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Slides 1-5 (2m:35s)
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Welcome to Introduction to Accounting Preparing for a User's Perspective
Liquidity Ratios: Quick Ratio, Working Capital, Cash Conversion Cycle
Liquidity Ratios: Quick ratio
To address some of the failings of the current ratio, the finance industry developed another liquidity ratio called the quick ratio
Links to an external site., also known as the quick assets ratio or the acid-test ratio. The quick ratio is a stricter, more conservative test of a company's true liquidity
Links to an external site.because it removes inventory from current assets in the numerator of the ratio. Inventory is left out of the calculation because it can often take many months to convert into cash and is much less liquid than other current assets. It then uses the remaining, more liquid, current assets
Links to an external site. to cover all of its current liabilities
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The quick ratio is computed as follows:
Let's compute LAC's quick ratios for 20X1 and 20X2. As you can see (in the video), we have only highlighted the most liquid current assets leaving out inventory and we have all current liabilities:
20X1 (Total Current Assets $49,000 - Inventories $17,000) / Total Current Liabilities $23,000 = 1.39
20X2 (Total Current Assets $48,000 - Inventories $7,000) / Total Current Liabilities $17,000 = 2.41
As you can see in 20X2, the company is more liquid [with a quick ratio of 2.41] than it was in 20X1 [with a quick ratio of 1.39].
Liquidity: What does the quick ratio tell us and what does it not tell us?
The 20X2 quick ratio of 2.41 indicates that LAC's most liquid assets should be readily able to provide $2.41 of cash to help it pay off each $1 of cash demanded by its current liabilities. LAC appears to be very "liquid" in 20X2.
By taking inventory out of the quick ratio's numerator, we are able to eliminate the cash flow timing issues brought on by inventories. However, because the quick ratio still includes accounts receivable, whose true future collection date is not perfectly known, the quick ratio will always just be an estimate of a company's liquidity. In the bizstats table for the Dairy Products industry above, the average quick ratio was .14 compared to the average current ratio of .71. Because the dairy industry's quick and current ratios are so different, it appears that a significant amount of the dairy industry's current assets are tied up in inventory.
If you are interested in learning more about the quick ratio, feel free to watch the investopedia.com video titled What is the quick ratio? Links to an external site.
Slides 6-7 (2m:06s)
Links to an external site.Liquidity Ratios: Working capital
Similar to the current and quick ratios, another means of assessing a company's liquidity is to compute its working capital
Links to an external site.. Working capital is the difference in amount between a company's current assets less current liabilities.
A quick analysis of LAC's balance sheet shows that its working capital was $26,000 in 20X1 (i.e. $49,000 current assets - $23,000 current liabilities) and $31,000 in 20X2 (i.e. $48,000 current assets - $17,000 current liabilities). Working capital indicates a company's liquidity as well as its efficiency. Liquidity indicating its ability to pay its short-term debts as they come due and efficiency
Links to an external site. indicating that it chooses to invest the excess current assets.
Liquidity: What does working capital tell us and what does it not tell us?
Working capital is widely used in finance, even if, like the current and quick ratios, it is an imperfect measure of liquidity. A working capital of less than $0 indicates that the company could struggle paying off its current liabilities when they come due. Large working capital amounts may indicate that the company is not investing its excess current assets to generate more income. Healthy, liquid companies should be able to avoid having to sell off their long-term assets such as vehicles, equipment, manufacturing plants, buildings, jumbo jets, to make their current liability payments because if they sell their long-term assets, they often reduce the company's ability to support operations and generate profits. For example, an airline that has to sell off its airplanes to pay its short-term creditors will have a tough time selling flights. This is probably a big reason why most airlines do not buy their planes but rather lease them.
Some analysts warn that users should not focus too much on working capital because, as with the current ratio, it does not tell the whole story of a company’s liquidity and related timing of cash flows. I agree which brings up the cash conversion cycle.
Slides 8-10 (1m:45s)
Links to an external site.Liquidity Ratios: Cash conversion cycle
Although working capital is an interesting and valuable number, users of financial statements need to look even deeper into a company’s financial statements using the cash conversion cycle to really understand its liquidity risks. The cash conversion cycle
Links to an external site. relies on numbers from both the balance sheet and the income statement such as "days of inventory outstanding", "days sales outstanding", and "days payables outstanding".
We will not discuss here how these days outstanding ratios are computed, but these three numbers (days of inventory outstanding + days sales outstanding - days payables outstanding) effectively indicate the number of days between when inventory is purchased then sold, plus the number of days it takes to receive payment on the sale, less the number of days the company takes to pay for the inventory it purchased.
Liquidity: What does the cash conversion cycle tell us?
The "cash conversion cycle" is another helpful tool in indicating a company’s true liquidity. The longer the cash conversion cycle, the less liquid the company is. The cash conversion cycle formula was created to address the weakness of the other ratios in that they mistakenly assume that current assets will be converted to cash evenly and that current liabilities will be paid off evenly. The cash conversion cycle should be considered along with a company's current ratio, quick ratio and working capital to better assess a company's liquidity.
Summary
The following liquidity ratios can help users assess a company's liquidity which is its ability to pay its current liabilities within the next year as they come due:
Liquidity
1) Current Ratio: Current assets / Current liabilities
2) Quick Ratio: (Current assets - inventories) / Current liabilities
3) Working Capital Current assets - Current liabilities
4) Cash Conversion Cycle: (days of inventory outstanding + days sales outstanding - days payables outstanding)
To assist you in assessing a company's liquidity, you should learn the names, computations and interpretations of all these ratios.
That's it for our liquidity ratios: quick ratio, working capital, cash conversion cycle. Good luck on the quiz.