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Monday, 16 January 2012

Financial Ratio Analysis:Liquidity Ratios

The company which is having greater liquidity assets is better than the company which is having low liquidity assets.
What is Liquidity:The company's ability to quickly convert an investment portfolio to cash with little or no loss in value.

There are 4 types of liquidity ratios.

1.Current Ratio: This Ratio is used to test a company's liquidity by deriving the proportion of current assets available to cover liabilities.

Current Ratio=Total Current Assets/Current Liabilities

The higher the current ratio,the better.

2.Quick Ratio: This ratio is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there to cover current liabilities.
A higher quick ratio means a more liquid current position.

Quick Ratio=Quick Assets/Current Liabilities.

Quick Assets=Total Current Assets-Inventory.

By excluding inventory, the quick ratio focuses on the more liquid assets of a company.

3.Cash Ratio: The cash Ratio is an indicator of a company's liquidity that further refines both the current ratio and the quick ratio by measuring the amount of cash,cash equivalents(or) invested funds are there in current assets to cover current liabilities.

Cash Ratio=Cash Assets/Current Liabilities.

Cash Assets=Total Current Assets-(Inventory+Account Receivables).

Very few company's will have enough cash and cash equivalents to fully cover current liabilities , which is not a bad thing , so need not to focus on this ratio being above 1:1.

4.Cash Conversion Cycle: The Cash Conversion Cycle measures the number of days a company's cash is tied up in the production and sales process of its operations and the benefit it gets from payments from its creditors.

The shorter this cycle the more liquid the company's working capital position is.

Cash Conversion Cycle=DIO+DSO-DPO

DIO=Days inventory outstanding 
DSO=Days Sales outstanding
DPO=Days payable s outstanding.

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