Liquidity Ratios: What are they?

Both the Current and Quick Ratio measure the firm’s ability to satisfy its current obligations/liabilities.

Current Ratio

Quick Ratio/ Acid-test Ratio

Since the Quick Ratio only takes into account cash, marketable securities and accounts receivable compared to Current Ratio which takes into account ALL current assets, the Quick Ratio is undoubtedly stricter. The recommended Current and Quick Ratio is 2 and 1 respectively.

However, there are companies with lower than the “recommended” levels. Why? That is because they can still maintain the same level of liquidity even at the lower levels! These companies often have strong operating cash flows which allow them to readily borrow from the capital markets at low cost in the event of any liquidity issues. Hence it poses no threat to their business solvency. Also, remember when I mentioned that carrying excess cash would lower the returns on asset and equity? It allows management to attain higher returns on asset and equity through using the cash to pay off debts or distribute to shareholders in terms of one-off dividends! (Yay!)

Debt to Equity

This ratio measures the level of debt in the business relative to the amount of shareholder equity within the business. In general, debt to equity ratios of 0.4 are considered good and any figure above 0.6 would be slightly troublesome as it could create hefty interest payments as well as potentially raise interest rates to elevated levels. However, it relates from business to business as some businesses inherently have higher levels of leverage such as commercial banks.

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2 Responses

  1. Jun Xiang says:

    Looks like a good revision for financial accounting AD1101 haha.

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