Liquidity
Short-term Liquidity
The following are generally expressed in N to 1 terms.
Current ratio
This measures a company's capacity to cover its current liabilities as they fall due.
How to calculate
Current assets
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Current liabilities
A manufacturer normally needs a current ratio of around 2:1. More than this suggests poor resource usage and potential liquidity problems.
Quick ratio or "acid test"
This test/ratio excludes slower-moving item (stock) from current assets and pinpoints real short-term liquidity.
How to calculate
Debtors + cash
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Current liabilities
Using/interpreting this ratio
For both current ratio and quick ratio we must be aware that
- Low ratios may indicate liquidity problems yet some businesses/industries (supermarkets once again) operate on tight liquidity ratios.
- high ratios look good but may pinpoint poor management of funds. Cash mountains may not offer the returns that shareholders are looking for.
- If we examine the make-up of the ratio we may find high stock levels. This may give a healthy current ratio but stock obsolescence may be evident affecting real stock valuations.
Long-term Liquidity
Gearing ratio
There are several variations but the general gearing ratio measures the relationship between a firm's borrowings and its shareholders' funds.
How to calculate
Fixed return capital (debentures, preference shares, loan stock
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Equity capital + reserves
Using/interpreting this ratio
Note:
- company cash flow stability. Strongly branded business can rely on stable cash flows. Such a company can borrow heavily against its brands/labels in order to fund acquisitions/expansion etc.
- policies to revaluate fixed assets may improve shareholders' funds and reduce gearing are popular as they avoid breaches of covenants when raising additional debt.
