LOS C requires us to:

##### compare a company’s liquidity position with that of peer companies

Liquidity ratios are covered in detail in Financial Reporting Analysis.

We can analyze a company’s liquidity position by analyzing and comparing the liquidity and activity ratios of a company with others in the industry or peers.

# 1. Liquidity Ratios

Liquidity ratios are the ratios that depict the ability of a company to meet its short-term obligations. Some of the common measures of liquidity of a company are:

## 1.1. Current Ratio

The current ratio assesses the adequacy of current assets to pay off the entity’s short-term liabilities. The common norm is 2:1. The current ratio can be calculated by using the formula:

## 1.2. Quick Ratio (Acid Test Ratio)

Quick Ratio assesses how adequate are the highly liquid current assets to settle the company’s short-term liabilities. Inventory is deducted as it is difficult to sell it urgently and prepaid expenses are deducted as it is not possible to cash it back once paid. Commonly, 1:1 is the norm. The quick ratio can be calculated using the formula:

## 1.3. Cash Ratio

This is a more stringent ratio considering only cash in hand, cash at the bank, and marketable securities as liquid assets to cover short-term liabilities. A higher ratio is better. It can be calculated as:

# 2. Activity Ratios

Activity Ratios are the measure of the efficiency of a firm. It measures the degree of efficiency with which a firm manages its assets and the operating efficiency of the firm. These ratios measure the ongoing operational performance of the firm.

Some of the activity ratios and their respective formulas are:

## 2.1. Inventory Turnover Ratio

This ratio shows the number of times the inventory is sold and replaced over the reporting period. It can be calculated as follows:

The lower the inventory turnover ratio, the longer the time between when the good is produced or purchased and when it is sold. Whereas, an abnormally high inventory turnover and a short processing time could mean inadequate inventory, which could lead to outages, backorders, and slow delivery to customers, adversely affecting sales. Meanwhile, an extremely low inventory turnover value implies capital is being tied up in inventory and could signal obsolete inventory.

## 2.2. Days of Inventory on Hand

This ratio measures the number of days a firm takes to sell its average balance of inventory. It can be calculated as follows:

## 2.3. Receivables Turnover Ratio

This ratio represents the number of times in a year a business collects its accounts receivables. This ratio can be calculated as follows:

The lower the turnover ratio, the more time it takes for a company to collect on a sale and the longer before a sale becomes cash. This ratio is a better and a detailed analysis tool than the current or quick ratio. A company could have a favorable current or quick ratio, but if the receivables turn over at a slower pace, the liquidity ratios would not be a good measure of liquidity. The same applies to the inventory turnover as well.

## 2.4. Days of Sales Outstanding

This ratio measures the number of days a firm takes to collect its revenues/receivables after the sales have been made. It can be calculated as follows:

## 2.5. Payables Turnover ratio

This ratio represents the number of times in a year a business pays to its account’s payables. It can be calculated as follows:

The longer the time, the better it is for the company, since it is an interest-free loan and offsets the lack of cash from receivables and inventory turnovers.

## 2.6. Number of Days Payable

This ratio measures the number of days a firm takes to pay its creditors after the purchases have been made. It can be calculated as follows:

## 2.7. Cash Conversion Cycle

The cash conversion cycle is the period that exists from when the company pays out money for the purchase of raw materials to the suppliers to when it gets the money back from the buyers of the company’s finished goods. This ratio can be calculated as follows: