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Recall that the concept of liquidity represents the ability of a company to repay its short-term creditors out of the cash that it has available. This liquidity can be represented by a ratio that compares assets to liabilities. There are a couple of ways to do this:
The current ratio is found by dividing the current assets by the current liabilities.
Acceptable current ratios vary from industry to industry but they are generally between one and a half and three for a healthy business. If a company has a ratio in this range, it generally indicates good short-term financial strength.
EXAMPLE
Here is the balance sheet of our fictitious ABC Company.The total current assets are $12,874, while the total current liabilities are $12,409. If we divide the current assets by the current liabilities, we get 1.05, which seems a little bit low. The company can barely repay its current liabilities from its current assets.
Now, can a current ratio be too high? If you are a shareholder and the current ratio is 4, are you happy because they are so liquid? Most likely, you would want that number to be lower, because that higher number means there is cash sitting there that is not being invested in growth or paid out in dividends.
The quick ratio, or the acid test, measures the ability of a company to use its cash or quick assets to retire its liabilities immediately. It is calculated by dividing the current assets minus the inventory by the current liabilities.
EXAMPLE
Let's take a look at the balance sheet for ABC Company again.We said that ABC Company has current assets of $12,874, but if we subtract the inventory of $5,560, then we only have the cash of $7,314. If we divide that by the current liabilities of $12,409, then we arrive at a quick ratio of 0.58. This shows we do not have nearly enough coverage to take care of our current liabilities in the short term.
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