Financial Health Ratios: Liquidity Ratios

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Video Transcription:

Hello, traders. Welcome to the Stock Trading Course and the sixth module, Investing Stock Picking.

Today we’re going to continue with the financial health ratios lesson. And we’re going to go through the second category, which is liquidity ratios. So liquidity ratios refers to a company’s capacity to meet its short-term obligations. A liquid company is also capable to sell assets quickly to raise cash. So the difference between liquidity ratios and solvency ratios is basically that liquidity ratios is going to measure how fast a company can sell its assets to pay for its short-term obligations.

We’re going to start with the current ratio. This ratio measures a company’s ability to pay its current liabilities on the short term, which is less than one year, with its current assets. These assets include cash in hand, account receivables, and inventories. The formula for current ratio is current assets divided by current liabilities. So a current ratio below one indicates that the company doesn’t enough assets to cover its liabilities.

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Let me put it this way, a current ratio of one would mean that the current assets and the current liabilities of the company are equal. For example, a company that has a current assets of a million dollars and current liabilities of a million dollars will have a current ratio of one. A current ratio below one indicates that the company or the company’s assets is smaller than the company’s current liabilities. A current ratio above one indicates that the company has enough assets to cover its short-term liabilities. So investors look for at least a better than one current ratio when evaluating a company’s liquidity. And because investors look for more than just the ability to cover its current short-term liabilities with its current assets, they are going to be looking for a current ratio of 1.5 or higher.

The second liquidity ratio we’re going to look at is the quick ratio, which is also called the acid-test ratio. This ratio is called the acid-test ratio because it measures a company’s ability to meet its short-term obligations with its most liquid assets. These excludes inventories, because in most sectors converting inventory into cash would not happen immediately. So basically what this ratio is going to measure is the ability of a company to overcome a worst case scenario where it would have to cover short-term obligations on that immediately.

This ratio indicates the ability of a company not to go bankrupt in a worst case scenario of economic downfall. Usually investors look at at least a quick ratio of one to one. The quick ratio formula is current assets minus inventories, divided by current liabilities. So by looking at a quick ratio of one, it means that investors are looking at companies that have the least risk of going bankrupt in a scenario where they would have to cover its immediate obligations with the sale of its more liquid assets.

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And the third ratio we’re going to look at, is the operating cash flow to sales ratio. Remember that these ratios are only to measure the company’s liquid status. So this ratio compares a company’s operating cash flow to its net sales or revenue. This ratio gives investors an idea of the company’s ability to turn sales into cash. And don’t be fooled by the name of this ratio. What we are measuring here is the ability of the management or the company’s management to manage its sales and account receivables. So operating cash flow to sales ratio formula is cash flow divided by revenue, times 100.

So this ratio is important to investors because it shows how quickly a company is being paid for the sale of its products and services. A drop in this ratio would mean that the company is doing a poor job in managing its account receivables. It’s very worrisome to see a company’s sales grow without a parallel grow in cash flow. Why? Because it’s illogical that the sales of a company are growing, but the injection of cash from those sales is not growing accordingly. So investors look for a high operating cash flow to sales ratio, because this means that the company is more liquid and has more cash in hand to pay its suppliers, employees, or reinvest in upgrades.

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