Liquidity Ratios

Liquidity ratios measure a firms short term cash flow.  This is important as they will have short term obligations to staff (wages) and suppliers amongst others.  Looking at then in isolation is of little value.  They must be compared with last years figures, competitors figures or industry averages (if available) in order to build up a picture.

Trade Payable collection period

Trade Payables                                 x 365 =  X days

Credit Purchases

Explanation: This is your trade payables as a proportion of your credit sales.  A higher figure means you wait x days before settling your bills.  Always round answers up to the next whole day.

Comparison:  higher the figure is better for your businesses liquidity 

Assessment: Paying early may mean you receive discounts – increasing profits. Paying late could also squeeze your suppliers’ cash flow.  Paying early will affect yours!

Note: - It is often useful to take Trade Receivable Days away from your Trade payable Days to show the overall credit cycle – a negative figure means you pay your credit suppliers after receiving money from your credit customers.  Quote the difference!

Trade Receivable Collection period

Trade Receivables           x 365 =  X days

    Credit Sales

Explanation: This is your trade receivables as a proportion of your credit sales.  A higher figure means you wait x day to receive your money.  Always round up to the nearest whole day.

Comparison:  lower the figure is better for your firm’s liquidity.

Assessment: Offering cash discounts to your credit customers can lower this and improve cash flow issues.  This should lower profits though and may also reduce sales.  It may reduce the chances of bad debts as there are fewer monies outstanding.

Note: - It is often useful to take Trade Receivable Days away from your Trade payable Days to show the overall credit cycle – a negative figure means you pay your credit suppliers after receiving money from your credit customers.  Quote the difference!

Net Current Asset ratio

   Current Assets               =  x:1

Current Liabilities

Explanation: This means that for every £1 of short term debt a firm has x pounds to pay the debt

Comparison:  higher the figure is safer for the businesses liquidity but not always better for your efficiency

Assessment: A high figure avoids cash flow problems but may mean your short term assets are not working as hard as they could.  The business could be sat on cash or inventory.  A low figure could mean being very efficient or that there are cash flow problems – particularly if most of the current assets are tied up in Trade Receivables / Inventory.

Liquid asset ratio

Current Assets (excluding inventory) =  x:1

Current Liabilities

Explanation: This means that for every £1 of short term debt a firm has x pounds of liquid assets (inventory can be hard to sell quickly!) to pay their short term debts

Comparison:  higher the figure is safer (Liquidity) but not always better (assets not working as hard as they could be!)

Assess: A high figure avoids cash flow problems but may mean short term assets are not working as hard as they could.  Low figures could mean being efficient or cash flow problems (particularly if most of the liquid assets are Trade Receivables)

NB A company with a high current Ratio but low liquid capital ratio has too much inventory!!  This is not good as it is could be hard to sell or perishable etc.

Inventory turnover

Average Stock   x 365 =  X days

Cost of Sales

Or

Cost of Sales     = X times a year

Average Stock

NB Average stock is opening stock plus closing divided by 2

Explanation: This means that inventory is kept for x days before it is sold (round up to the nearest whole day)

Comparison:  the lower the figure is almost always better in days (higher is better in times per year version)

Assessment: Firms with low days of inventory may be more efficient by reducing wastage or theft.   However they may not have enough inventory to fully meet demand which could lose the company sales if deliveries are late.