Liquidity ratios

1. Liquidity ratios

Hello again! It's time to make you a financial investigator. We have looked at the balance sheet and income statement. We will use both to do some key financial analysis and focus on liquidity ratios in this video.

2. Performance measurements

Key Performance indicators, or KPIs, are a set of measurements used to tell how well a firm is performing. The measurements a company selects depend on the type of business and what drives a company's sales. If KPIs are well-defined and aligned with the company's goals and activities, they can become very useful. In this video, we will focus on ratios commonly used as KPIs.

3. Financial ratio analysis

Financial Ratio Analysis is a type of KPI that expresses the relationship among selected items contained within financial statement data. We will learn two types of ratios, liquidity and profitability ratios. In this video, we will focus on liquidity ratios.

4. Liquidity ratios

Liquidity ratios are used to determine the ability of a company to pay its obligations. For example, you pay rent, a car payment, and a portion of your student loan every month. Your ability to pay these expenses using cash helps determine your liquidity. There are many liquidity ratios; we will focus on three main ratios used by analysts, the current ratio, acid-test, and inventory turnover.

5. Current ratio

The current ratio, also known as the working capital ratio, compares current assets to current liabilities. The goal of this ratio is to measure the short-term ability of the company to pay debt. This ratio is calculated by utilizing information from the balance sheet and dividing current assets by current liabilities. For example, in 2017, the current asset is $1,020,000, and the current liabilities were $344,500. The current ratio is expressed as two point 96 to one. This ratio means that Larry's Automotive has two dollars and 96 cents of assets for every dollar of current liabilities. Analysts consider a current ratio of two to one the standard for a good credit rating.

6. Acid-test ratio

The acid test ratio tells us the short-term liquidity of a company. The equation is cash plus short-term investments plus accounts receivables divided by current liabilities. For example, we can see that in 2017, the acid-test ratio for Larry's Automotive was 1 point 02 to 1. If an acid test is greater than one, a company is considered to be capable of meeting short-term liabilities.

7. Inventory turnover

Inventory Turnover measures the number of times the inventory is sold during a specific period. We need information from the balance sheet and income statement for this ratio. Inventory Turnover is subsequently the Cost of Good Sold (COGs) divided by the Average Inventory. For example, the inventory turnover of Larry's Automotive is $1,281,000 divided by the average inventory of 2017 and 2018 of $620,000 plus $500,000. We see we get an inventory turnover of 2 point 3 times. To make this number relevant to industry values, we convert it into days that inventory is held. We see that Larry's Automotive turnover inventory is every 159 days versus 30 days, which is the industry average for automotive makers. This tells us that Larry's Automotive is struggling to sell its vehicles. You are now starting to see how these numbers prove very helpful to analysts and the management team.

8. Let's practice!

Let's dive into some exercises!

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