Include the current ratio and quick ratio.
Liquidity ratios are used to determine a company's ability to pay off its short-term debt.
Generally, the higher the value of the particular ratio the better, as this provides a greater margin of safety to cover these debts.
The ratios include the current ratio, the quick ratio and the operating cash flow ratio. Different assets may be relevant in calculating liquidity and this gives rise to the different ratios.
Banks and other finance originators use these ratios to determine whether a company has not fallen into a liquidity trap and can continue as a going concern.
Three Common Liquidity Ratios
The current ratio is calculated as current assets divided by current liabilities. It is also referred to as the cash ratio or the cash assets ratio. It is considered desirable that this ratio is greater than 1.0.
The quick ratio is measured by current assets minus inventories divided by current liabilities and as such is more conservative than the current ratio. The reason for this is that some companies may have more difficulty in turning stock into cash to reduce debt.
The quick ratio is also referred to as the quick assets ratio or the acid test ratio. This ratio should also be greater than 1.0.
The operating cash flow ratio is measured by dividing the cash flow from operations by the current liabilities. The idea behind this ratio is that as cash is what is used to pay creditors, the use of the cash flow from company operations provides a more useful measure.
From a value investing point of view, it is important to gauge whether a company has the ability to turn short-term assets into cash to cover debts, particularly when creditors are seeking payment.
Taking note of these common ratios before investing in a company provides some security that a company is in a sound financial position and that it is more likely to keep its creditors happy.
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