Liquidity is defined
as the ability of a business to generate cash, and liquidity ratios measure the
ability to pay off obligations as they mature. Short-term liquidity is the ratio
of current assets to current liabilities of a company. Following ratios are
computed to measure short-term liquidity:
Current Ratio
This measures the
ability of a company to pay its current liabilities such as accounts payables,
short-term notes payables etc. Current liabilities are used as denominators as
they represent most urgent debts maturing within an operating cycle or one year
which ever is longer. Current assets, representing most liquid assets are taken
as numerator for meeting those liabilities. The current ratio can be calculated
as follows:
=
Current Assets
Current Liabilities
This ratio is a good
barometer to measure short-term liquidity but it has some limitations. Some
items such as prepaid expenses represent early settlement of future liabilities
and are not potential sources of cash. Similarly, accounts receivable and
inventories may not be truly liquid. Some companies with very high current
ratios may not be able to meet their current liabilities, due to inferior
quality of accounts receivable (may be a result of loose credit policy) or slow
moving inventories which can only be sold at discounted prices. Thus it is
necessary to use some other measure in conjunction with the current ratio such
as cash flow from operations and liquidity of other assets.
Quick Ratio
Quick Ratio or Acid
test ratio is similar to the current ratio, except it provides a more rigorous
test of short-term liquidity of the company. As mentioned earlier, prepaid
expenses, store and spares and inventory may not have high liquidity. For this
reason less liquid current assets are excluded from the numerator.
=
Cash + Marketable Securities + Account Receivable
Current Liabilities
Cash Flow Per
Share
Cash flow is crucial
for the day-to-day running of business activities and it is closely linked to
the long-term survival of the organization. Profitability does not guarantee
cash flow, therefore it's prudent to give due consideration to cash flow
management. Cash flow per share measures the liquid cash and cash equivalents in
a business in per share terms.
=
Net Income plus Non-cash Adjustments
Number of Shares Outstanding
Operating Cash Flow Ratio
This cash flow ratio
measures the ability of the firm to generate operational cash to meet current
liabilities as they fall due. Operational cash flow depends upon the nature of
the industry, and some industries generate substantial cash flows. Therefore,
conclusions should be made after referring to industry data.
=
Operating Cash Flow
Current Liabilities
Cash Flow to Total Debt Ratio
This ratio indicates the cash flow
available to cover total debt obligation of the company. Banks and long-term
debt holders would be interested in this ratio as it provides insight to the
company’s ability to repay the future debt obligations.
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