Liquidity Ratios

Now, let’s jump into our first section of ratios, the liquidity ratios. These liquidity ratios are some of the most tested ratios on the exam. For liquidity, there’s a big emphasis on current assets and current liabilities.

Current means that it’s going to happen within a year. Current assets are assets that will be converted into cash within one year.

The following are current assets:

• Cash and cash equivalents
• Marketable securities
• Accounts receivable
• Prepaid expenses
• Inventory

The most liquid current asset is cash, because liquid means you’re able to convert it into cash, and cash is already cash. The least liquid current assets are prepaid expenses and Inventory.

An important measure of liquidity is called working capital. Working capital is simply current assets minus current liabilities. It answers the question, “How much money will we have left over after we pay our current liabilities?”

Working Capital = Current Assets – Current Liabilities

For example, let’s say that your cash is $5,000, your AR is $10,000, $0 in marketable securities, and $7,000 of inventory. Your total current assets are $22,000. Then let’s say that your current liabilities are $10,000. It means that in the next year, your current assets of $22,000 is going to become cash. Then with that $22,000 of cash, you’re going to pay for your $10,000 of current liabilities. Therefore the working capital is $12,000.

The next kind of ratio is called the current ratio, which is current assets divided by current liabilities. This ratio asks, “How many more current assets do you have compared to current liabilities?” In other words, “For every $1 of current liabilities, how many dollars of current assets do you have?”

Current Ratio = Current Assets / Current Liabilities

We mentioned earlier how prepaid expenses and inventory are not very liquid current assets, which is why we have something called the quick ratio. The quick ratio only focuses on the most liquid current assets, which are cash, accounts receivable, and marketable securities.

If we calculate the quick ratio with our numbers, we would have cash of $10,000 and AR of $5,000, totaling $15,000 in quick assets. Our current liabilities are still $12,000, so our quick ratio is 1.25 ($15,000/$12,000). Meaning that we have 1.25 times more quick current assets than current liabilities. In other words, for every $1 of current liabilities, we have $1.25 of highly liquid current assets.

The operating cash flow ratio is the cash flow from operations divided by the current liabilities.

Operating Cash Flow = Cash Flow from Operations / Current Liabilities