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While liquidity ratios are most helpful for short-term creditors/suppliers and bankers, they are also important to financial
managers who must meet obligations to suppliers of credit and various government agencies. A complete liquidity ratio
analysis can help uncover weaknesses in the financial position of your business.
| Current Assets* | = Current Ratio |
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| Current Liabilities* |
Popular since the turn of the century, this test of solvency balances your current assets against your current
liabilities. The current ratio will disclose balance sheet changes that net working capital will not.
*Current Assets = net of contingent liabilities on notes receivable
*Current Liabilities = all debt due within one year of statement data
Note: The current ratio reveals your business's ability to meet its current obligations. However,
it should be supplemented with the other ratios listed below.
| Cash + Marketable Securities + Accounts Receivable (net) | = Quick Ratio |
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| Current Liabilities |
Also known as the "acid test ratio", this ratio specifies whether your current assets that could be quickly converted into cash are
sufficient to cover current liabilities. Until recently, a Current Ratio of 2:1 was considered standard. A firm that
had additional sufficient quick assets available to creditors was believed to be in sound financial condition.
Note: The Quick Ratio assumes that all assets are of equal liquidity. Receivables are one step closer
to liquidity than inventory. However, sales are not complete until the money is in hand.
| Cash + Marketable Securities | = Absolute Liquidity Ratio |
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| Current Liabilities |
A subsequent innovation in ratio analysis, the Absolute Liquidity Ratio eliminates any unknowns surrounding receivables.
Note: The Absolute Liquidity Ratio only tests short-term liquidity in terms of cash and marketable securities.
| (Cash + Receivables + Marketable Securities) | = Basic Defense Interval |
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| (Operating Expenses + Interest + Income Taxes) / 365 |
If for some reason all of your revenues were to suddenly cease, the Basic Defense Interval would help determine the number of days your
company can cover its cash expenses without the aid of additional financing.
| Total Credit Sales | = Receivables Turnover Ratio |
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| Average Receivables Owing |
Another indicator of liquidity, Receivables Turnover Ratio can also indicate management's efficiency in employing those funds invested
in receivables. Net credit sales, while preferable, may be replaced in the formula with net total sales for an industry-wide
comparison.
Note: Closely monitoring this ratio on a monthly or quarterly basis can quickly underscore any change in collections.
| (Accounts + Notes Receivable) | = Average Collection Period Ratio |
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| (Annual Net Credit Sales) / 365 |
The Average Collection Period (ACP) is another litmus test for the quality of your receivables business, giving you the average length of
the collection period. As a rule, outstanding receivables should not exceed credit terms by 10-15 days. If you allow
various types of credit transactions, such as a retail outlet selling both on open credit and installment, then the ACP must be calculated
separately for each category.
Note: Discounted notes which create contingent liabilities must be added back into receivables.
| Cost of Goods Sold | = Inventory Turnover Ratio |
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| Average Inventory |
Rule of Thumb: Multiply your inventory turnover by your gross margin percentage. If the result is 100 percent or greater, your
average inventory is not too high.
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