Objectives

• Describe how to utilize different liquidity ratios in determining a company’s ability to pay its short-term debt obligations to help companies manage risk, make smart decisions, predict future finances, and inform stakeholders about financial health.

 

Topic Outline

• Liquidity Ratios

• Sensitivity Analysis

• Exceptions

• Summary

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Key Definitions

• Ratios - are comparisons, either over time or against benchmarks, that depict relationships between financial statement accounts or between financial statement accounts and nonfinancial data. Also, it offers additional insights into a company's financial health beyond the raw figures provided in the financial statements.

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I. Liquidity Ratios

 

Liquidity Ratios are relative measures of the proximity of current assets and current liabilities to cash and are an indication of a company’s ability to meet its short-term obligations. Since most of the liabilities of a company are paid in cash, a good measure of this ability is how rapidly a company can convert its other assets into cash, if the need arises.

 

A. Working Capital Analysis

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Working capital or Net Working Capital is a measure of a company's ability in the short run to pay its obligations. It looks at short-term financial health.

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B. Current Ratio

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Current Ratio measures the degree to which current assets cover current liabilities. A higher ratio indicates greater ability to pay current liabilities with current assets, thus greater liquidity. Additionally, it focuses solely on the immediate relationship between current assets and liabilities. 

• Liquidity issues can impact the company's overall financial health, affecting its ability to meet long-term obligations (solvency) and efficiently utilize assets (operational activity). 

• While a current ratio of 2.0 or higher is traditionally seen as healthy for manufacturing companies, however, in the current e-business landscape, a lower ratio may be deemed acceptable.

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C. Quick (Acid-Test Ratio)

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Quick (Acid-Test) Ratio examines liquidity from a more immediate aspect than does the current ratio by eliminating inventory and prepaid expenses from current assets. The quick ratio removes inventory because it turns over at a slower rate than receivables or cash and assumes that the company will be able to sell the items to a customer and collect cash.

• While the quick ratio is a robust indicator of liquidity, it's not infallible, and qualitative factors like credit terms with suppliers and customers also play a crucial role in assessing liquidity.

• Exercise caution with accounts receivable, particularly when they involve significant receivables with unusual trade terms or from related parties, as their collection pattern and associated risks may deviate from normal receivables.

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D. Cash Ratio

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Cash Ratio analyzes liquidity in a more conservative manner than the quick ratio, by looking at a company's immediate liquidity. The cash ratio compares only cash and marketable securities to current liabilities, eliminating all current accounts receivable and inventory from the asset portion. When using this formula, cash and cash equivalents are used for the term "cash" in the numerator.

• A firm typically doesn't possess enough cash equivalents and marketable securities to cover current liabilities. Despite this, the cash ratio can be beneficial for companies with slow inventory turnover or receivables collection.

• A high cash ratio may suggest underutilization of resources in operations. Conversely, a low cash ratio could indicate difficulty in meeting current liabilities.

• The inclusion of marketable securities in the cash ratio poses a limitation, as these may need to be liquidated to settle debts. Marketable securities' volatile value renders the ratio, computed based on year-end prices, potentially invalid over longer timeframes.

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E. Cash Flow Ratio

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Cash Flow Ratio measures a firm's ability to meet its debt obligations with cash generated in the normal course of business. The numerator amount normally will be operating cash flow shown on the current period statement of cash flows.

• A higher operating cash flow ratio suggests a higher probability of the company meeting its obligations using cash generated from regular operations.

• A declining cash flow ratio over time signals potential liquidity issues on the horizon.

• If a company experiences a net operating cash outflow, this calculation is not applicable as it would not yield valid results.

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II. Sensitivity Analysis on Liquidity Ratios

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When analyzing the ratios, it is important to gauge how sensitive these ratios are to changes in their components. An increase in the numerator of a ratio will increase the value of the ratio, whereas an increase in the denominator of a ratio will reduce the value of the ratio, and vice versa. Since a higher number is preferable for these ratios, a decrease in the numerator or an increase in the denominator adversely affects the ratio and inferences made.

 

• Thus, an increase in liabilities would adversely affect the ratio, whereas an increase in current assets or cash flows would improve the ratios. The amount of increase or decrease in a particular ratio depends on the value of the ratio.

• It should be noted that an equal increase in both the numerator and the denominator of the ratio would worsen the ratio if the ratio is greater than 1. However, an equal decrease in both the numerator and denominator would improve a ratio that is greater than 1.

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III. Exceptions

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These are the three (3) exceptions needed to be considered and understood in liquidity ratios:

 

1. Prepaid expenses have already been paid in cash and will never be converted into cash. They will be reported as expenses, most often, with the passage of time.

 

2. Unearned revenue represents amounts already collected from the customer but the earning process for that amount is not complete.

3. Deferred income tax is not paid as such until the deferral evolves into calculation of the current income tax liability, which is paid.

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IV. Summary of Liquidity Ratios

These are the different liquidity ratios to remember:

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Understanding liquidity ratios is essential for Certified Management Accountants (CMAs) as it is a fundamental concept tested in the financial reporting and analysis sections of the exam. Liquidity ratios provide insights into a company's ability to meet short-term obligations, aiding CMAs in financial decision-making, risk management, and strategic planning within organizations. By identifying potential liquidity risks and assessing the organization's financial health, CMAs can develop strategies to mitigate risks, allocate resources effectively, and communicate financial information clearly to stakeholders, including executives, investors, and board members. Therefore, proficiency in liquidity ratios is crucial for CMAs to excel in their roles and pass the exam successfully.

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PRACTICE QUESTIONS

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1. All of the following are affected when merchandise is purchased on credit except:

*Source: Retired ICMA CMA Exam Questions

A. Current Ratio.

B. Total Current Assets.

C. Net Working Capital.

D. Total Current Liabilities.

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2. Of Peterson Enterprises' $1.4 billion in assets, only $150 million of those assets are in cash or can be readily converted to cash. This is an example of:

A. high liquidity

B. high solvency 

C. low liquidity

D. low solvency

 

3. Zenk Co. wrote off obsolete inventory of $100,000 during Year 1. What was the effect of this write-off on Zenk's ratio analysis?

 

A. Decrease in current ratio but not in quick ratio 

B. Decrease in quick ratio but not in current ratio

C. Increase in current ratio but not in quick ratio

D. Increase in quick ratio but not in current ratio

 

4. Smith Enterprises runs half-day yacht tours off the coast of Oahu. To meet borrowing covenants in the operating line of credit, accountant Christopher Johns must somehow increase the current ratio above the current level of 1.4. Of the following options, Johns is most likely to: 

 

A. purchase supplies on credit

B. use cash to retire a short-term note payable to creditor Anderson

C. sell two of the company's marketable securities (price equal to book value)

D. ask employees Hinkley, Summer, and Grant to go an extra week without being paid

 

5. When a firm's current assets exceed its current liabilities, the firm's _______________ if the firm pays off a short-term liability.

 

A. current ratio will increase

B. current ratio will decrease

C. current ratio will remain the same

D. working capital will increase

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6. CPZ Enterprises had the following account information.

 

Accounts Receivable                             $ 200,000

Accounts Payable                                        80,000

Bonds payable, due in ten years              300,000

Cash                                                             100,000

Interest payable, due in three months      10,000

Inventory                                                     400,000

Land                                                            250,000

Notes payable, due in six months            50,000

Prepaid expenses                                       40,000

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The company has an operating cycle of five months.

 

What will happen to the ratios below if CPZ Enterprises uses cash to pay 50% of the accounts payable, and both ratios are greater than 1.0 prior to the payment?

 

A. Current Ratio: Increase; Quick Ratio: Increase

B. Current Ratio: Decrease; Quick Ratio: Increase

C. Current Ratio: Increase; Quick Ratio: Decrease

D. Current Ratio: Decrease; Quick Ratio: Decrease

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7. Val-Tek has current assets of $1,700,000 and current liabilities of $900,000. If the company pays $100,000 owed to a creditor, what will its new current ratio be?

 

A. 4:1

B. 2:1

C. 1:1

D. 1.5:1

 

8. A firm's total assets are $10,000,000, its total liabilities are $4,000,000, its current assets are $2,800,000 ($600,000 cash, $1,000,000 money market investments, $700,000 inventory, and $500,000 receivables), its current liabilities are $900,000 ($400,000 accounts payable, $500,000 notes payable), and its equity is $6,000,000. Its operating cash flow is $1,500,000. What is the firm's cash flow ratio?

 

A. 1.5

B. 3.75

C. 1.67

D. 3

 

9. The Downtown Company has current assets of $2,400,000. Of these, $750,000 is cash, $1,000,000 is accounts receivable, and the remainder is inventory. Current liabilities are $1,250,000.

Determine the company's acid-test ratio, rounding to two decimal places.

 

A. 1.40

B. 1.92

C. 2.69

D. 1.32

 

10. Potential creditors for Addison Enterprises want to determine Addison's liquidity. If Addison has current assets of $942 million and current liabilities of $735 million, which of the following would provide an accurate measure of Addison's liquidity?

 

A. A debt to asset ratio of 128%

B. A debt to asset ratio of 78%

C. A current ratio of 1.28:1

D. A current ratio of 0.78:1

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ANSWER KEY

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1. Answer: c. Net Working Capital

 

When merchandise is purchased on credit, total current assets increase and total current liabilities increase by the same amount, therefore, the net working capital (current assets - current liabilities) remains the same when merchandise is purchased on credit. The current ratio, however, will change.

 

2. Answer: c. low liquidity

 

Liquidity addresses a company's ability to pay its short-term liabilities. High liquidity means a company has a relatively large percentage of its assets in cash or in items that can be readily converted into cash. Since only $150 million of $1.4 billion in assets are in cash or can be readily converted into cash, this company has low liquidity. Therefore, this is the correct answer.

 

3. Answer: a. Decrease in current ratio but not in quick ratio

 

As inventory is excluded in the quick ratio, the write-off of obsolete inventory would have no effect on the quick ratio; however, it would decrease the current ratio as the write-off would reduce current assets.

 

4. Answer: b. use cash to retire a short-term note payable to creditor Anderson

 

Since the current ratio is greater than one, decreasing a current asset to decrease a current liability will increase the current ratio.

 

5. Answer: a. current ratio will increase

 

Paying off a current liability reduces current assets and current liabilities by the same dollar amount. Since current assets exceed current liabilities, the percentage reduction in current liabilities is greater than the percentage change in current assets. When the numerator (current assets) decreases by a smaller percentage than the denominator (current liabilities), the figure increases. Therefore, this is the correct answer.

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6. Answer:  a. Current Ratio: Increase; Quick Ratio: Increase

 

Since both the current ratio and the quick ratio are greater than one, the change will increase both ratios. For example, if prior to the payment, the current assets were equal to $200, the quick assets were $150, and the current liabilities were $100, then the original current ratio would be $200 ÷ $100 = 2 and the original quick ratio would be $150 ÷ $100 = 1.5. Assuming that the current liabilities are all accounts payable, the payment on 50% of the accounts payable balance would reduce the current assets to $150, the quick assets to $100, and the current liabilities to $50. The new current ratio would then be $150 ÷ $50 = 3. The new quick ratio would be $100 ÷ $50 = 2. By using this example, one can see that both the current ratio and quick ratio have increased because of CPZ Enterprises using cash to pay off 50% of the account payable balance.

 

7. Answer:  b. 2:1

 

One of the most common ratios used to assess liquidity is the current ratio. It is defined as Current Assets ÷ Current Liabilities. It measures the amount of current assets available per dollar of current liabilities. Higher current ratios indicate higher liquidity, as there are more current assets available to satisfy current liabilities. If the company pays a creditor $100,000, current assets will decrease to $1,600,000 ($1,700,000 - $100,000) (assuming a current asset such as cash is used to pay the creditor) and current liabilities will decrease to $800,000 ($900,000 - $100,000). The new current ratio will be 2.0 ($1,600,000 ÷ $800,000). Therefore, this is the correct answer.

 

8. Answer:  c. 1.67

 

Cash flow ratio = Operating Cash Flow ÷ Current Liabilities = $1,500,000 ÷ $900,000 = 1.67.

 

9. Answer:  a. 1.40

 

One of the most common ratios used to assess liquidity is the acid-test ratio. Sometimes called the quick ratio, it is defined as Quick Assets ÷ Current Liabilities. Quick assets are the most liquid current assets. They include cash, short-term investments, and accounts receivable. Inventory is not a quick asset as it takes a relatively long period of time to convert inventory into cash. A higher quick ratio indicates greater liquidity, as there are more quick assets available to satisfy current liabilities. Downtown's acid-test ratio is 1.40 [$1,750,000 ($1,000,000 + $750,000) ÷ $1,250,000]. Therefore, this is the correct answer.

 

10. Answer:  c. A current ratio of 1.28:1

 

Liquidity measures a company's ability to pay its short-term liabilities. One of the most common ratios used to assess liquidity is the current ratio. It is defined as Current Assets ÷ Current Liabilities. Higher current ratios indicate greater liquidity, as there are more current assets available to satisfy current liabilities. This company's current ratio is 1.28 ($942 million ÷ $735 million). This will provide an accurate measure of Addison's liquidity.

 

References:

Wiley. (2023). Wiley CMA Exam Review 2023 Study Guide Part 2: Strategic Financial Management Set (1-year access). Wiley.

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