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Liquidity Ratio Basics

Analyzing Firms

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Liquidity measures a company’s ability to survive short term. This measures a firm’s ability to pay it’s short-term or current liability requirements. Any firm who cannot pay these requirements is dead in the short term unless it quickly makes arrangements to pay its bills. The larger the total of current assets, especially cash, in relation to current liabilities, the safer a company is. This should be the starting point for analyzing a company. If a business can’t pay short-term debts, you should find a new firm to invest in.

Turnover Ratios

Liquidity can be identified by more than the current and quick ratios. “Turnover” ratios also relate to liquidity. Turnover ratios are composed of Asset Turnover, Accounts Receivable Turnover, Inventory Turnover, and Accounts Payable Turnover. The turnover speed can increase or decrease liquidity. Faster turnover of asset classes and slower turnover of liability classes both increase liquidity.

Turnover equations function as a ratio that is used to divide the year’s days. As an example, when an Inventory level of one dollar divides four dollars of Cost of Goods Sold, a turnover of four will be the result. Four indicates the quantity of times per year the Inventory turns over. The turnover can be used to find the actual period of days that inventory takes to turn over, known as the turnover period. The turnover period is simply found by dividing the year by the turnover. In this example, four divides 365 days of the year and the turnover period results in 91.2 days.

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