Capital Ratios: Operating/Liquidity
February 11th, 2010
Copyright © 2010 Integrated Profitability TM
Capital ratios that concentrate on operating/liquidity relationships are primarily focused on the immediate and short-term operation of the business. Operating ratios help owners track their ability to meet short-term obligations. These (balance sheet) ratios are complementary to the following, income statement, items:
● Cash flow
● Daily and/or ongoing liquidity
The purpose of these particular ratios is to monitor the company’s ability to keep the business afloat in the short-run. Depending on how fast cash is being spent and received, operating ratios can also help forecast how long before running into operating (solvency) problems.
The major operating ratios are*1:
1. Current Ratio
Current ratio = current assets / current liabilities
Measures whether current liabilities will be paid from current assets. A ratio of 1.0 is breakeven; higher is better.
2. Quick Ratio (Acid Test)
Quick Ratio = (current assets – inventory) / current liabilities
Measures whether the most liquid assets will be sufficient to pay current liabilities
(Note:
Current assets include cash, marketable securities, accounts receivables and inventory
Current liabilities include accounts payable, short-term notes payable, current maturities of long-term debt, and accrued expenses & income taxes)
Here is a useful website:
If your business is small enough, you probably carry these ratios around in your head. And deal with them every day. Still, when all goes well and your business grows, you will have much more important things to work on. Regularly reported operating ratios will be an ongoing connection to how well your expanding business is doing in this critical area.
Bill
William A. Stong
Email: william.a.stong@gmail.com
SBF&P # 53
Telephone: 925-202-6244
Copyright © 2010 Integrated Profitability TM
*1: Eugene F. Brigham, Fundamentals of Financial Management (Illinois: Dryden Press, 1978) p. 125.
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