In assessing the liquidity position of a company outsiders use as their two
key indicators the current ratio and the liquidity ratio. The following points have to be noted. One is that all ratios are imperfect and imprecise and should only be treated as informal guidelines. The second arising from the first is that while the company must take account of these
ratios, it ought not to regard them as iron laws governing all aspects of financial management.
The impression can be misleading, particularly if the company is engaged in a business subject to cyclical variation.
The current ratio equals Current Assets divided by Current Liabilities
The satisfactory ratio which is taken to indicate that the company's short term financial position is healthy is 2:1. A lower ratio than this, say 1.5:1, commonly implies a shaky short term position.
The liquidity ratio is Quick Assets Current Liabilities
Quick Assets Current Liabilities
Quick Assets are defined as all current assets except stocks. Working
Capital requirements can vary from industry to industry and a particular
company needs to compare its own situation with companies in the same
industry. It is bad financial management to allow the current ratio to become too high e.g. a ratio of 2.5:1 would make a company a very sound client for anyone thinking of giving it credit but the company's shareholders might reasonably be less happy with the situation. For a company to have a current ratio of 2.5:1 would mean that it has not made the best use of borrowing possibilities. It will be advisable for the company to utilise short term loan facility to push the current liabilities higher to give a ratio of 2:1. If the company does not do that, another company might purchase the company's shares on a share for share basis and so
successfully expand its borrowing base.
Liquidity ratios have two further important limitations.
(1) Any thorough assessment of a company's working capital should
take into account the bank overdraft ceiling. This is not usually shown in the annual accounts, but the freedom to borrow from the bank can put a remarkably different complexion on the recorded liquidity position. A company whose liquidity position is far below
1 to 1 could be a perfectly safe debtor if it had adequate overdraft facilities in reserves.
(2) The liquidity ratios are all static; they do not reflect the company's changeable financial situation. If the current liabilities of a company exceed its liquid assets, it is relevant to know how quickly the situation could be remedied without drastic measures. Earnings could be the important factor.
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