Have you ever wondered what it means for a company to be liquid? Most of us have at least a vague understanding of liquidity - the idea that a business can meet its short-term obligations. But how is this vague idea actually calculated? Today, we are going to look at some commonly used working capital management metrics - that is, measures of how efficiently a company uses its current assets to manage its working capital.
The current ratio
This is probably the simplest measure of a company’s liquidity. It is calculated by dividing current assets by current liabilities, and it provides a relatively unsophisticated view of whether a company is able to meet its short-term liabilities. A higher number indicates that it has a lot of assets that can be used to service liability needs; a lower number indicates there are fewer assets that can be used for this purpose. A current ratio of less than one indicates the company in question has negative working capital, which could indicate that it is in danger of becoming illiquid.
The quick ratio
Not all current assets can be readily liquidated in order to service liabilities. For instance, a business may have a lot of inventory that is difficult to sell, either because it is highly specialized or unwanted or obsolete. Therefore, it is not always appropriate to include inventories when calculating a company’s liquidity. The quick ratio accounts for this by subtracting inventories from current assets, then dividing them by current liabilities.
Note that for companies in industries that are inventory-heavy, like retail, a negative quick ratio can be misleading. As with all financial metrics and ratios, a dose of common sense needs to be applied. Also, having a very high current or quick ratio is not necessarily a good thing - it could mean that the company in question has a lot of cash that is just sitting there doing nothing. Excess capital should always either be reinvested or returned to shareholders.
Receivables turnover ratio
This ratio is a measure of how good a company is at collecting the money it is owned by customers and other parties. Extending credit is a very normal thing in business, but at a certain point, you have to be able to convert the "I owe yous" into real cash. The receivables turnover ratio is calculated by taking net credit sales and dividing it by the average amount of accounts receivable.
A high receivables turnover ratio signifies that a company’s customers are creditworthy, that they pay their debts on time or that it is very effective at collecting the money that it is owed. Alternatively, it could mean the company is very conservative when it comes to advancing credit, and that it prefers to operate on a cash-only basis.
A low receivables turnover ratio is a sign that counterparties are not repaying the money that they owe the company, that it does business with individuals with bad credit or that its debt collection policies are inadequate in some way. Such companies are more likely to fall into liquidity traps, as they have less access to the cash they may be owed.
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