The following ratios are designed to assess the
liquidity of the company, in other words, the ability of the company
to meet its short term commitments as they fall due. This is an
important aspect of risk management, and can be useful in
determining a company’s probability of default or likelihood of
insolvency. This is important for more conservative or prudent
investors in equity – and for all investors in debt securities
(i.e. lenders).
Net working capital
= Current Assets less Current Liabilities (see statement of
financial position). This figure shows the net difference
between current assets and liabilities.
Current ratio
= Current Assets divided by Current Liabilities. This figure
measures the ratio of current assets to liabilities, which in
essence is similar to net working capital, however this ratio is
a common size figure, or it ignores absolute values so it can be
used to compare across companies more easily. Again though this
ratio will differ depending on the industry and business model,
for instance banks and financial institutions mismatch the
maturities of their assets and liabilities which is basically
the process of intermediation – which is their raison
d'ętre... and main source of risks and profits.
Quick ratio
= Current assets less inventory divided by current liabilities –
this is the same ratio as above however it allows for the fact
that inventory is generally a lot less liquid. An extension of
this is to use the cash ratio which only includes cash and
marketable securities, on the rationale that accounts receivable
may also be misleading as a proxy for liquid/short term
assets… especially if there is high credit concentration or
slow conversion rates.
Working
capital ratio
= net working capital over total assets – this measures net
working capital as a proportion of total assets, essentially it
is a common size ratio designed to compare working capital
across companies.
