4-2: LIQUIDITY RATIOS
The liquidity ratios help answer this question: Will the firm be able to pay off its debts as they come due and thus remain a viable organization? If the answer is no, liquidity must be the first order of business.
A liquid asset is one that trades in an active market and thus can be quickly converted to cash at the going market price. As shown in Table 3.1 in Chapter 3, Allied has $310 million of debt that must be paid off within the coming year.
Will it have trouble meeting that obligation? A full liquidity analysis requires the use of a cash budget, which we discuss in Chapter 16; however, by relating cash and other current assets to current liabilities, ratio analysis provides a quick and easy-to-use measure of liquidity. Two of the most commonly used liquidity ratios are discussed below.
Liquid Asset
An asset that can be converted to cash quickly without having to reduce the asset’s price very much.
Liquidity Ratios
Ratios that show the relationship of a firm’s cash and other current assets to its current liabilities.
4-2a: Current Ratio
The primary liquidity ratio is the current ratio, which is calculated by dividing current assets by current liabilities:
Current ratio = Current assets Current liabilities = $ 1 , 000$ 310 = 3.2 × Industry average = 4 .2 ×
Current Ratio
This ratio is calculated by dividing current assets by current liabilities. It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future.
Current assets include cash, marketable securities, accounts receivable, and inventories. Allied’s current liabilities consist of accounts payable, accrued wages and taxes, and short-term notes payable to its bank, all of which are due within one year.
