Liquidity Ratios: Cash and Working Capital

Profitability is of course an important aspect of a company’s performance, and Debt or Gearing is another.

However, none addresses the key issue of liquidity.

A company needs liquid assets so that it can meet its debts when they fall due.

Liquidity is the amount of cash a company can obtain quickly to settle its debts (and possibly to meet other unforeseen demands for cash payments too).

Liquid funds consist of:

(a) Cash
(b) Short-term investments for which there is a ready market, such as investments in shares of other companies. (Short-term investments are distinct from investments in shares in subsidiaries or associated companies).
(c) Fixed term deposits with a bank or building society, for example ix month deposits with a bank.
(d) Trade Receivables – they are not cash, but ought to be expected to pay what they owe within a reasonable short time.
(e) Bills of exchange receivable – like ordinary trade receivables, these represent amounts of cash due to be received soon.

Liquidity Ratios and Working Capital Turnover Ratios can give us some ideas of the company’s liquidity


Liquidity Ratios

(1) Current ratio = Current Assets / Current Liabilities

In practice a current ratio comfortably in excess of 1 should be expected, but what is comfortable varies between different types of businesses.


(2) Quick Ratio or Acid Test Ratio = (Current Assets less Inventory) / Current Liabilities

The ratio should ideally be at least 1 for companies with a slow inventory turnover For companies with a fast inventory turnover, a Quick Ratio can be less than 1 without suggesting that the company is in cash flow difficulties.

An excessive large current / quick ratio may indicate a company that is over-investing in working capital, suggesting poor management of debtors or stocks by the company.


Working Capital Turnover Ratios

Turnover Periods for Inventory, Receivables and Payables can be calculated.

If we add together the inventory days and the receivables days, this should give us an indication of how soon inventory is convertible into cash.

Both receivables days and inventory days therefore give us a further indication of the company’s liquidity.


(source: BPP Learning Media)



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