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This article was first published on Jul 2, 2014
One popular financial ratio to calculate a company’s liquidity position is using the current ratio.
Current ratio is defined by dividing a company’s current assets by its current liabilities. The principle of the current ratio determines how a company would be able to pay off its short-term liabilities from its short-term assets. A quick breakdown of what accounts for a firm’s current assets and current liabilities can be shown below:
|Cash and cash equivalentAccounts receivablesInventory
|Short-term debtAccounts payableAccrued liabilities
Apart from finance companies such as banks and insurance firms, the current ratio can be used for almost any company including manufacturing firms and retailers. An excerpt of Broadway Industrial’s (SGX: B69) financial statement below shows how we can easily calculate its current ratio:
|Cash and cash equivalents
|Trade and other receivables
|Loans and borrowings
|Trade and other payable
|Current tax liabilities
Source: Company report
Based on the calculation made, the company has maintained a stable current ratio of 1.06x between 2012 and 2013. On both years, Broadway Industrial’s short-term assets are able to pay off its short-term obligations over the next 12 months. An increasing trend would suggest that a company is in a better position to pay off its current liabilities. However, if the current ratio is less than 1, the company might have difficulty paying off its short-term liabilities if they come due at that point. This means that the company’s bills are coming in faster than it can generate cash from its short-term assets.
We can apply a more conservative form of liquidity measurement ratio such as the acid-test ratio (current assets minus inventories / current liabilities) and the cash ratio (cash and cash equivalents / current liabilities). Although the cash ratio is rarely used since very few firms would have enough cash to cover its current liabilities, the cash ratio is useful to identify whether the company has been utilizing cash to deploy into investments. Thus, a high cash ratio would thus be questionable.
Value in Action
Liquidity measurement ratios such as the current ratio, acid-test ratio and cash ratio allow the investor to determine whether the management is effective in maintaining adequate liquidity of the company. Poor management of short-term assets and liabilities often leads to a deterioration of the liquidity ratios, which should bring attention to the investor.
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