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Questions and Answers
What is the purpose of liquidity ratios in financial analysis?
What is the purpose of liquidity ratios in financial analysis?
- Assess a company's long-term financial health
- Analyze a company's short-term financial situation (correct)
- Predict a company's stock market performance
- Evaluate a company's ability to generate revenue
How is the current ratio calculated?
How is the current ratio calculated?
- By dividing current assets by total assets
- By dividing total assets by current liabilities
- By dividing current liabilities by total liabilities
- By dividing current assets by current liabilities (correct)
Why is the quick ratio considered a more accurate measure of liquidity than the current ratio?
Why is the quick ratio considered a more accurate measure of liquidity than the current ratio?
- It focuses on fixed assets rather than liquid assets
- It excludes inventory from current assets (correct)
- It provides a clearer picture of long-term obligations
- It includes inventory in current assets
What does a high cash ratio indicate about a company's liquidity position?
What does a high cash ratio indicate about a company's liquidity position?
What impact can an excessively high current ratio have on a company's operations?
What impact can an excessively high current ratio have on a company's operations?
Which liquidity ratio specifically focuses on a company's most liquid assets?
Which liquidity ratio specifically focuses on a company's most liquid assets?
What does the cash conversion cycle measure?
What does the cash conversion cycle measure?
What does a shorter cash conversion cycle indicate?
What does a shorter cash conversion cycle indicate?
How is the receivables turnover ratio calculated?
How is the receivables turnover ratio calculated?
What does a higher receivables turnover ratio indicate?
What does a higher receivables turnover ratio indicate?
How is the inventory turnover ratio calculated?
How is the inventory turnover ratio calculated?
What does a higher working capital turnover ratio indicate?
What does a higher working capital turnover ratio indicate?
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Study Notes
Ratio Analysis: Liquidity Ratios
Ratio analysis is a crucial tool for investors, creditors, and financial analysts to assess a company's financial health and performance. Specifically, liquidity ratios provide insights into a company's short-term financial situation, its ability to repay debts, and how efficiently it is utilizing assets to generate cash.
Current Ratio
The current ratio is a widely used liquidity ratio that measures a company's ability to meet its short-term obligations. It is calculated by dividing a company's current assets by its current liabilities. Higher current ratios indicate better liquidity, as they represent the number of times current assets can cover current liabilities. However, a ratio that is too high might suggest the company isn't effectively utilizing its excess cash for growth.
Quick Ratio
The quick ratio is a more conservative version of the current ratio. It measures a company's ability to meet its short-term obligations by excluding inventory from current assets. This ratio provides a more accurate picture of a company's liquidity, as inventory can be difficult to convert into cash quickly.
Cash Ratio
The cash ratio is another liquidity ratio that measures a company's ability to meet its short-term obligations with its most liquid assets. It is calculated by dividing a company's cash and cash equivalents by its current liabilities. A higher cash ratio indicates a stronger liquidity position.
Cash Conversion Cycle (CCC)
The cash conversion cycle, also known as the operating cash flow cycle, measures the time it takes for a company to generate cash from its operating activities. It is calculated by subtracting the inventory turnover from the accounts receivable turnover and then adding the average collection period. A shorter cash conversion cycle indicates better liquidity and operational efficiency.
Operating Cash Flow Ratio
The operating cash flow ratio compares a company's total cash flow from operations to its current liabilities. It provides insight into a company's ability to generate cash from its core operations to meet its short-term obligations.
Receivables Turnover
The receivables turnover ratio measures the number of times a company collects its accounts receivable during a period. It is calculated by dividing net credit sales by average accounts receivable. A higher turnover ratio indicates better liquidity, as it shows that a company is collecting its accounts receivable more efficiently.
Inventory Turnover
The inventory turnover ratio measures the number of times a company sells and replaces its inventory during a period. It is calculated by dividing the cost of goods sold by average inventory. A higher turnover ratio indicates better liquidity, as it shows that a company is managing its inventory more efficiently.
Working Capital Turnover
The working capital turnover ratio measures the efficiency with which a company is using its working capital to generate revenue. It is calculated by dividing net sales by average working capital. A higher turnover ratio indicates better liquidity, as it shows that a company is effectively using its working capital to generate revenue.
In summary, liquidity ratios are essential tools for assessing a company's ability to meet its short-term obligations and its operational efficiency. By analyzing these ratios, investors and financial analysts can gain a better understanding of a company's financial health and performance.
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