3.8 Liquidity Ratios

Liquidity ratios can be traced back to emergence of ratio analysis when banks started to demand financial statements in the latter 19^th century.  These ratios are designed to provide an indicator of a firm’s ability to repay its debts over the next twelve months.  As a result, they are computed from the current assets and liabilities section of the balance sheet.  Recall, the previous topic introduced working capital ratios.  These ratios let a user assess how efficiently a firm is transforming its inventory into sales and how the firm is managing to collect its receivables and pay its payables.  Liquidity ratios complement this working capital analysis by extending this to the analysis to assess whether a firm can meet its short run or current obligations.

A further distinction can be made in the subsequent topic, between liquidity and solvency.  Liquidity adopts a short run focus whereas solvency adopts a longer term focus.  Solvency ratios assess whether a company is likely to be able to repay their debts in the longer run and thus whether they are a going concern.  In the next section on financial leverage we introduce debt ratios that are relevant to assessing solvency.

The primary liquidity ratios are the Current Ratio and its major liquidity refinements the Quick and the Cash Ratios.  The Quick and Cash Ratios focus upon a firm’s ability to immediately repay its obligations.  These are defined as follows:

A major property of the Quick Ratio is that Inventory is excluded from Current Assets because this requires effort to convert into cash plus it may only be quickly convertible at a significant discount.  Similarly, for Accounts Receivable but the discount is usually much smaller especially since the emergence of securitization.  Securitization is the process of combining different company’s accounts receivable and issuing securities against their cash flows that are sold to investors.

Tutor Reconciliation:  Proctor and Gamble (PG)

Our objective is to reconcile the following from the 10-K:

Step 1:  Bring up the Balance Sheet for Proctor and Gamble as described in section 3.2.  For this example we will bring up two Balance Sheets instead of both the Balance Sheet and Income Statement.  This is displayed at the bottom of the screen as follows:

For Proctor and Gamble you can see the “Total Current Assets” ($18,782) as P&G describe it and Accounts Receivable are $5,335.

Similarly, total Inventories $6,384 and scrolling down reveals the working capital items on the Balance Sheet.

Step 2:  Click on Calculate and we can verify the input and derived fields for the following:

Current Ratio = 0.7735

Quick Ratio = 0.3383

Cash Ratio = 0.1186

In step 1 we extracted the relevant aggregate numbers from the 10-K and so the full reconciliation can now be traced through as follows.