Name: _______________________________________ Class Number: ___________

Course & Section: ______________________________ Date: ___________________

FIN 081: Financial Management

LESSON TITLE:

LIQUIDITY RATIOS

Lesson Objectives: Materials:

At the end of this module, I should be able to:  Student Activity
1. Explain the importance of liquidity ratio to the investors and Sheet’s
creditors.

2. Determine the four main liquidity ratios.

3. Calculate and use liquidity ratios to evaluate the ability of a

firm to meet its current obligations.
Productivity Tip: After the discussion, try to solve similar problems given in this module. By practicing
solving problems, you will be able to understand the topic yourself and better understand and master the
concepts and formulas.

This document is the property of PHINMA EDUCATION

 FIN 081: Financial Management
Student Activity Sheet

A. MAIN LESSON

What is LIQUIDITY RATIOS?

 A Liquidity Ratio, is one of the common types of Financial Ratios, it is used to evaluate a
company's ability to repay short-term debt.

Why do we need Liquidity Ratio?

 Liquidity Ratios can tell us how easily a company can pay its debts.
 Ratios that give us an idea of the firm’s ability to pay off debts that
are maturing within the next operating cycle.
 A statistic helps determine whether a company has enough liquid, or
current, assets to cover its short-term obligations.

Importance of Liquidity Ratios to Investors and Creditors:

 Investors and creditors use liquidity measures to assess a company's
ability to pay short-term obligations and to what extent. Although it
isn't ideal, a ratio of 1 is preferable to one that is less than 1. Higher
liquidity ratios, like 2 or 3, are preferred by creditors and investors.

How to use Liquidity Ratios?

Liquidity ratios have four (4) main ratios which are:

1. CURRENT RATIO
 Measures of the firm's ability to pay current liabilities with current assets.
 It is the simplest liquidity ratio to calculate and interpret.

FORMULA: CURRENT ASSETS - Cash and other assets that are expected to be
converted to cash within a year.

FORMULA:
Current assets = Cash and Cash Equivalents + Accounts Receivable +
Inventory + Marketable Securities.
Current Assets
Current Ratio=
Current Liabilities
CURRENT LIABILITIES - a company's debts or obligations that are
due to be paid to creditors within one year.

FORMULA:
Current Liabilities = (Notes Payable) + (Accounts Payable) + (Short-
Term Loans) + (Accrued Expenses) + (Unearned Revenue) + (Current
Portion of Long-Term Debts) + (Other Short-Term Debts)

This document is the property of PHINMA EDUCATION

 FIN 081: Financial Management
Student Activity Sheet

The Current Ratio is called short-term because it includes all current assets and current liabilities,
unlike other liquidity ratios. The current ratio is sometimes referred to as the working capital ratio.

ILLUSTRATED PROBLEM:
(Solve the TOTAL AMOUNT to further understand the computation by using the given formula.)

ABC Enterprise showed the following items in its balance sheet for December 31, 20X1:

20x1 20x2
Assets
Current Assets
Cash ₱ 2,040.5 1,195.0
Marketable securities 3,636.0 4,005.0
Account receivables 4,705.0 4,385.5
Allowance for doubtful accounts (225.0) (208.5)
Investors 23,530.5 18,390.5
Prepaid expenses 260.0 380.5
Total current assets 33,947.0 28,148.0

Liabilities
Current Liabilities
Accounts payable ₱ 7,150.0 3,800.5
Notes payable – banks 2,810.0 3,100.0
Current maturities of long-term debt 945.0 760.0
Accrued liabilities 2,835.5 2660.5
Total current liabilities 13,740.5 10,321.0

STEP #1: Write the Formula.

Current Assets
Current Ratio = Current Liabilities

STEP #2:
20x1 20x2

33,947.0 28,148.0
Current Ratio= Current Ratio=
13,740.5 10,321.0

Current Ratio = 2.47 Current Ratio = 2.73

This document is the property of PHINMA EDUCATION

 FIN 081: Financial Management
Student Activity Sheet

Need to remember from CURRENT RATIO!

 A current ratio compares all of a company's current assets to its current liabilities.
 Liquidity ratios help investors learn more about a company's ability to cover its short- term
debt with its current assets and how it compares to peers.
 These are generally defined as assets that are cash or will be converted to cash
within one year and liabilities that will be paid within one year.
 A weakness of the current ratio is that it is difficult to compare metrics across
industries.
 Others include over generalization of specific asset and liability balances and
lack of trend information.

2. QUICK RATIO or ACID-TEST RATIO

 It compares a company's shortest term assets with its shortest term liabilities to determine
whether the company has enough cash to meet its immediate liabilities, such of paying off short-
term debt.

If a company has receivables that are taking longer than usual to collect, or current liabilities that are
coming due but do not need to be paid immediately, the Acid-test ratio may not provide a reliable
picture of the company's financial position.

FORMULA:

(Cash+ Marketable Securities+ Accounts Receivable)

Quick Ratio=
Current Liabilities

CASH - is the amount of actual MARKETABLE SECURITIES - are ACCOUNTS RECEIVABLE

cash available to a business. A
money (currency) that is readily
available for use.
 Coins.
 Currency.
 Cash in checking
accounts.
 Cash in savings accounts.
 Bank drafts.
 Money orders.
assets or liquid financial
instruments that can be quickly
converted into cash at a reasonable
price.
 Money Market Securities
o Treasury Bills (TB)
o Certificate of Deposit
(CD)
o Commercial Paper
(AR) - is the amount of
business for goods or services
supplied or used by the
customer but not yet paid for.
 Sales of goods on
account
 Supply of Service
 Deferred Revenue –
Sale of Magazine
 Money Lending

This document is the property of PHINMA EDUCATION

 FIN 081: Financial Management
Student Activity Sheet

 Petty cash. o Banker's Acceptance Industries

o Repurchase
Agreements.
 Capital Market Securities
o Stocks
o Bonds
o Real estate investment
trusts (REITs)
 Derivatives
o Futures contracts
o Options contracts
o Credit default swaps
 Indirect Investments

ILLUSTRATED PROBLEM:
(Solve the TOTAL AMOUNT to further understand the computation by using the given formula.)

ASSETS 20x1 20x2

Current Asset
Cash 2,040.5 1,195.0
Marketable Securities 3,636.0 4,005.0
Accounts Receivable 4,705.0 4,385.5
Allowance for doubtful account (225.0) (208.5)
Inventories 23,530.5 18,390.5
Prepaid Expenses 260.0 380.5
TOTAL CURRENT ASSETS 33,947.0 28,148.0

Property, Plant, and Equipment

Land 405.5 405.05
Buildings and leasehold improvements 9,136.5 5,964.0
Equipment 10,761.5 6,884.0
20,303.5 13,253.5
Less Accum. Dep. and Amortization (5764.0) (3,765.0)
Net Property, plant and equipment 14,539.5 9,488.5
Other Assets 186.5 334.0
Total Assets 47,649.0 37,954.5

LIABILITIES and EQUITY 20x1 20x2

Current Liabilities
Accounts payable 7,147.0 3,795.5
Notes payable – banks 2,807.0 3,006.0
Current maturities of long-term debt 942.0 758.0
Accrued liabilities 2,834.5 2,656.5

This document is the property of PHINMA EDUCATION

 FIN 081: Financial Management
Student Activity Sheet

Total Current Liabilities 13,730.5 10,216.0

Deffered Income Taxes 421.5 317.5

Long-term Debt
Total Liabilities 10,529.5 8,487.5
24,681.5 19,021.0
Equity
Ordinary shares, par value 1, authorized 10,000,0000
shares; issued, 2,297,000 shares in 20X4 and 2,401,500
shares in 20X3
Additional paid-in capital 2,401.5 2,297
Retained earnings 478.5 455.0
Total equity 20,967.5 16,181.5
22,967.5 18,933.5
Total Liabilities and Equity
47,649.0 37,954.5

Solving:
(Cash+ Marketable Securities+ Account Receivable , net)
Quick or Acid-test Ratio ¿ Total Current Liabilities

20x1 20x2

Quick/Acid-test Ratio = Quick/Acid-test Ratio =

[2,040.5+3,636+ ( 4,705−225 ) ] [ 1,195+4,005+ ( 4,385.5−208.5 )]
13,730.5 10,216

(5,676.5+ 4,480) (5,200+ 4,177)

= =
13,730.5 1 0,216

10,156.5 9,377
= =
13,730.5 10,216

Quick/Acid-test Ratio = 0.74 times Quick/Acid-test Ratio = 0.92 times

Remember: Allowance for doubtful account is a Contra Asset that should deduct on the Account
receivable to get the A/R, net.

Need to remember from QUICK or ACID-TEST RATIO!

 The acid test ignores assets such as inventory that may be difficult to

This document is the property of PHINMA EDUCATION

 FIN 081: Financial Management
Student Activity Sheet

liquidate quickly.
 The acid test ratio is more conservative metric.
 Company with a probability test less than 1 do not have enough cash to pay their current
liabilities and should be treated with caution.
 If the Quick Ratio is much lower than the current ratio, it means that the company's working
capital depends heavily on inventory.

This document is the property of PHINMA EDUCATION

 FIN 081: Financial Management
Student Activity Sheet

3. ACCOUNTS RECEIVABLE TURNOVER RATIO

- It is an accounting measure used to determine a company’s efficiency in collecting receivables
from their clients.

Investors should be aware that certain business compute their ratios using total sales rather than net
sales, which could lead to an inflated outcome.

FORMULA:
NET CREDIT SALES – revenues that a company
makes from the credit that it extends to clients
after deducting all sales returns and sales
allowance.
FORMULA:
Net Credit Sales = Sales on Credit – Sales Returns –
Sales Allowances

Net Credit Sales

ARTR=
Average Accounts Receivable
AVERAGE ACCOUNT RECEIVABLE - is the
average balance of accounts receivable during the
reporting period. An important part of the accounts
receivable turnover calculation.

FORMULA:
Beginning AR+ Ending
Average Account Receivable=
2

Include in the Accounts Receivable Turnover Ratio formula:

( Beginning Accounts Receivable+ Ending Accounts Receivable)
Average Accounts Receivable =
2

Number of Days∈a year

Accounts Receivable turnover in days =
Accounts Receivable Turnover ratio

This document is the property of PHINMA EDUCATION

 FIN 081: Financial Management
Student Activity Sheet

ILLUSTRATED PROBLEM:
(Solve the TOTAL AMOUNT to further understand the computation by using the given formula.)
Sheldy's Bike Shop is a retail store that sells biking equipment and bikes. Due to declining cash sales, Ariel,
the CEO, decides to extend credit sales to all his customers. In the fiscal year ended December 31, 2017,
there were ₱100,000 gross credit sales and returns of ₱20,000 and sales allowance of ₱15,000. Starting and
ending accounts receivable for the year were ₱10,000 and ₱15,000, respectively. Ariel wants to know how
many times his company collects its average accounts receivable over the year.

Formula:

Net Credit Sales

Accounts Receivable Turnover Ratio =
Average Accounts Receivable

65,000
= 12,500

= 5.2 times

Net Credit Sales = Sales On Credit - Sales Returns - Sales Allowance

= ₱100,000 - ₱20,000 - ₱15,000 = ₱65,000

Average Accounts Receivable = Beginning Inventory + Ending Inventory / 2

= (₱10,000+ ₱15,000) / 2 = 12,500

( Beginning Accounts Receivable+ Ending Accounts Receivable)

Average Accounts Receivable =
2

( ₱ 10,000+ ₱ 15,000)
= 2

( ₱ 25 ,000)
= 2

This document is the property of PHINMA EDUCATION

 FIN 081: Financial Management
Student Activity Sheet

= 12,500

Number of Days∈a year

Accounts Receivable turnover in days =
Accounts Receivable Turnover ratio

Using 360 days: Using 365 days:

360 365
= =
5.2 5.2

= 69.23 days = 70.19 days

Need to remember from ACCOUNTS RECEIVABLE TURNOVER RATIO!

 Inventory turnover measures how often a company replaces inventory against its cost of goods sold. In
general, the higher the ratio, the better.
 Low inventory turnover can be a sign of overstock, also known as poor sales or stock.
 Inventory turns are only useful when comparing similar companies and are especially
important for retailers.
 A relatively low inventory turnover rate can indicate poor sales or excess inventory.
On the other hand, a high ratio indicates good sales, but may also indicate
insufficient inventory levels.
 On the other hand, high inventory turnover indicates good sales.

4. INVENTORY TURNOVER RATIO

- It measures how efficiently a company uses inventory by dividing the cost of goods sold during
the period by the average inventory value.

Low inventory turnover ratio are beneficial during periods of inflation or supply chain disruptions,
when they reflect inventory build-up ahead of supplier price increases and increased demand.

FORMULA:

Cost of Good Sold

Inventory Turnover Ratio=
Average Inventory
COST OF GOOD SOLD (COGS) - Refers to the direct costs of
producing the goods that a company sells. This amount AVERAGE INVENTORY- Refers to the direct costs of
includes the cost of materials and labor directly used in producing the goods that a company sells. This amount
manufacturing the goods. It excludes indirect expenses, includes the cost of materials and labor directly used in
such as distribution costs and sales force costs. It excludes manufacturing the goods. It excludes indirect expenses, such
indirect as distribution costs and sales force costs. It excludes
This expenses,
document such
is as
thedistribution
propertycosts and sales force
of PHINMA EDUCATION
indirect expenses, such as distribution costs and sales force
costs.
FORMULA: costs.
COGS = Beginning Inventory + Purchase during the period – Ending FORMULA:
 2

FIN 081: Financial Management

Student Activity Sheet

Include in the Inventory Turnover Ratio formula:

( Beginning Inventory + Ending Inventory )

Average inventory =
2

Cost Of Good Sold (COGS)

Inventory turnover ratio =
Average Inventory

ILLUSTRATED PROLEM:

True JYP Co. is a Korean based small trading company. The company reports net sales of $75,000 and gross
profit of $35,000 on its 2022 income statement. The opening and closing inventory balances are $9,000 and
$7,000 respectively. Calculate average inventory levels, inventory turns, and average time to sell for 2022.

Solution:

( Beginning Inventory + Ending Inventory )

Average inventory =
2

( $ 9,000+ $ 7,000)
=
2
$ 16,000
=
2
= $8,000

Cost Of Good Sold (COGS)

Inventory turnover ratio =
Average Inventory

$ 40,000
=
$ 8,000

= 5 times

Cost of goods sold = Sales – Gross profit

This document is the property of PHINMA EDUCATION

 FIN 081: Financial Management
Student Activity Sheet

= $75,000 – $35,000
= $40,000

Number of days∈a year

Inventory turnover in Days =
Inventory turnover ratio

Using 360 days: Using 365 days:

360 365
= 5 = 5

= 72 days = 73 days

Need to remember from INVENTORY TURNOVER RATIO!

 Inventory turnover calculates the efficiency with which a company uses its
inventory by dividing the cost of goods sold by the average inventory value
over the period.
 Inventory turnover ratios, which are especially important for retailers, are only
useful when comparing similar companies.
 A low inventory turnover ratio may indicate weak sales or excess inventory,
whereas a high ratio indicates strong sales but may also indicate
insufficient inventory stocking.

 “Once we accept our limits, we go beyond them.” “No matter who you are, no matter what you did, no matter
where you've come from, you can always change, become a better version of yourself.”

This document is the property of PHINMA EDUCATION