Liquidity Ratio Analysis And Example

5 June 2

Definition: Liquidity ratios give a common approximation of the solvency of a company.

Here are a list of common liquidity ratios and formulas:

1) Current ratio (also known as a working capital ratio)

= Current Assets / Current Liabilities

2) Fast ratio, in times (also known as the acid test ratio or Fast assets ratio)

= (Current Assets – Stock) / Current Liabilities

6) Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities

3) Interest Coverage = Profit previous to Tax / Interest Charge

4) Gearing ratio = Long Term Liabilities / Equity Shareholders’ Funds

5) Cash Ratio = Cash / Current Liabilities

Example:

Calculate the operational capital, gearing ratios and acid test and given the following figures:

Debtors: $20,000

Creditors: $6,000

Bank: $11,000

Cash: $1,000

Closing stock: $6,000

Opening stock: $7,000

Total Capital and Reserves: $25,000

Long term loan: $15,000

Solution:

Working capital ratio = 20,000 / 6,000 = 3.33 (This means that current assets are 3.33 times current liabilities)

Current asset = debtors + bank + cash + closing stock = 20000 + 11000 + 1000 + 6000 = $38,000

Equity Shareholders’ Funds = Total Capital and Reserves + Long term Liabilities = 25000 + 15000 = $40,000

Gearing ratio = 15,000 / 40,000 = 0.375

Acid test ratio = (20,000 – 6,000) / 6,000 = 2.33 (This means that current assets in liquid form are 2.33 times current liabilities)

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