Liquidity Ratios and Activity Ratios

2126 Words Oct 28th, 2010 9 Pages
2.0 FINANCIAL RATIOS

2 Liquidity Ratios

Liquidity ratios measure a business ' capacity to pay its debts as they come due. It also measures the cooperative’s ability to meet short-term obligations. Liquidity refers to the solvency of the firm’s overall financial position – the ease with which it can pay its bills. Because a common precursor to financial distress and bankruptcy is low or declining liquidity, these ratios can provide early signs of cash flow problems and impending business failure. The two basic measures of liquidity are the current ratio and the quick (acid test) ratio (Gitman, 2009).

1. Current ratios

The current ratio is current assets divided by current liabilities. The current ratio
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No ratio, in fact, is especially meaningful without knowledge of the business from which it originates. For example, a declining quick ratio with a stable current ratio may indicate that a company has built up too much inventory, but it could also suggest that the company has greatly improved its collection system. Quick ratio is expressed as follows:

Quick Ratio = Current assets – Inventory / Current Liabilities Figure 2.2 explained the company’s quick ratio has been improving from year on year from 0.51 in 2007 to 0.63 in 2008 and then increased to 0.69 in 2009. Quick ratio for 2009 is higher compared to the industry average quick ratio that is 0.65. Even though it has shown incremental improvement of their quick ratio and surpassed the industry average of 0.65 acid tests, the firm would have to sell inventory to meet its obligations. Comparing quick ratios over an extended period of time can be used to signal developing trends in a company. While modest declines in the quick ratio do not automatically spell trouble, uncovering the reasons for changes can help to find ways to nip potential problems in the bud. As for PJV’s case, this is a good sign that the company progress steadily in improving its quick ratio over 3 years period in which may be resulting from its reduced inventories in 2009. The company’s quick ratio can further be increased to a satisfactory level (at least 1:1) by improving its collection system and policy. Like the
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