# Ratio Analysis Ratio Analysis QUICK RATIO Question: What is the quick ratio and how is it used?

Answer: The quick ratio, sometimes called the acid-test, is a more stringent test of liq uidity than the current ratio. This is because it removes inventory from the equ ation. Inventory is the least liquid of all the current assets. A business has t o find a buyer if it wants to liquidate inventory, or turn it into cash. Finding a buyer is not always easy. Calculation of the Quick Ratio The quick ratio is calculated from balance sheet data. Current Assets - Inventory/Current Liabilities Example: If a business firm has \$200 in current assets and \$50 in inventory and \$100 in c urrent liabilities, the calculation is \$200-\$50/\$100 = 1.50X. The "X" (times) pa rt at the end is important. It means that the firm can pay its current liabiliti es from its current assets (less inventory) one and a half times over. Liquidity ratios are used to evaluate the firm's ability to pay its short-term d ebt obligations such as accounts payable (payments to suppliers) and accrued tax es and wages. Short-term notes payable to a bank, for example, may also be relev ant. Interpretation and Analysis This is obviously a good position for the firm to be in. It can meet its short-t erm debt obligations with no stress. If the quick ratio was less than 1.00X, the n the firm would have to sell inventory to meet its obligations So, a quick rati o great than 1.00X is better than a quick ratio of less than 1.00X with regard t o maintaining liquidity and not being forced into the position of having to sell inventory. CURRENT RATIO Question: What is the current ratio and how do you measure it? Answer: The current ratio is probably the best known and most often used of the liquidit y ratios. Liquidity ratios are used to evaluate the firm's ability to pay its sh ort-term debt obligations such as accounts payable (payments to suppliers) and a ccrued taxes and wages. Short-term notes payable to a bank, for example, may als o be relevant. On the balance sheet, the current portions of the document are assets and liabil ities that convert to cash within one year. Current assets and current liabiliti es make up the current ratio. Calculation of the Current Ratio The current ratio is calculated from balance sheet data as Current Assets/Curren t Liabilities. So, if a business firm has \$200 in current assets and \$100 in cur rent liabilities, the calculation is \$200/\$100 = 2.00X. The "X" (times) part at the end is important. It means that the firm can pay its current liabilities fro m its current assets two times over. Intrepretation and Analysis This is obviously a good position for the firm to be in. It can meet its short-t erm debt obligations with no stress. If the current ratio was less than 1.00X, t hen the firm would have a problem meeting its bills. So, usually, a higher curre nt ratio is better than a lower current ratio with regard to maintaining liquidi ty. NET WORKING CAPITAL Question: What is net working capital and how is it measured? Answer: Net working capital is a financial metric a business owner can use in order to h elp measure the cash and operating liquidity position of the business firm.

The net working capital metric is directly related to the current ratio. If you look at the calculation of the current ratio, you see that you use the same bala nce sheet data to calculate net working capital. Here is the calculation for Net Working Capital: Current Assets - Current Liabil ities = Net Working Capital. If a business firm has current assets of \$200 and current liabilities of \$100, t hen: â ¢ Net Working Capital = Current Assets - Current Liabilities â ¢ =\$200 - \$100 â ¢ =Net Working Capital=\$100 This firm can pay its short-term debt obligations and still have \$100 left over as a cash or operating liquidity cushion. It has twice the current assets (\$200) as current liabilities (\$100). Compare this to the current ratio. If you calculate the current ratio for this e xample, you would use the current ratio formula: â ¢ Current Ratio = Current Assets/Current Liabilities â ¢ \$200/\$100 = 2.00X â ¢ Current ratio = 2.00X You can see the relationship between the two financial metrics. Cash management and the management of operating liquidity is important for the s urvival of the business firm. A firm can make a profit, but if they have a probl em with their cash position, they won't survive. This is why it is important for a business owner to use all the financial metrics and measures available to man age liquidity and cash.