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This article was first published on Jul 2, 2014

water

 

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:

 

Current Assets Current Liabilities
Cash and cash equivalentAccounts receivablesInventory

Short-term investments

Prepaid expenses

Short-term debtAccounts payableAccrued liabilities

Other payable

 

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:

 

S$ ‘000 2013 2012
Cash and cash equivalents 36,171 17,556
Inventories 93,325 93,095
Trade and other receivables 146,481 127,325
Current assets 275,977 237,976
Loans and borrowings 90,815 86,567
Trade and other payable 155,983 125,262
Current tax liabilities 14,627 13,369
Current liabilities 261,425 225,198
Current ratio 1.06x 1.06x

 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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The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie doesn’t own shares in any companies mentioned above.

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