Media and Journalism Course
Business and Economic Reporting
Liquidity
Liquidity refers to a company's ability to meet its requirements for
cash. Liquidity is necessary to meet both expected and unexpected
cash demands, so all businesses need liquidity to operate. Too little
liquidity can stunt growth and ultimately could lead to bankruptcy if
debts cannot be repaid. However, too much liquidity can detract from
profits, because liquid assets are low returning investments.
Current Ratio
The standard measure of liquidity is the current ratio, calculated by
dividing current assets by current liabilities. A Current Ratio should
always be greater than 1 to be a “liquid company”.
Generally, high quality companies have lower current ratios, as these
companies have easy access to capital markets if they find they
unexpectedly require cash.
Smaller companies, however, should have higher current ratios to
meet unexpected cash requirements. The rule of thumb current ratio
for small companies is 2:1, indicating the need for a level of safety in
the ability to cover unforeseen cash needs from current assets. That
is, the business has twice as much short-term assets compared to the
current liabilities. This is considered financially safe in the short-term
in case all short-term obligations need to be met urgently.
Throughout this week we are using the fictitious YouGood company
as an example to show you the figures you will need to understand.
Here is YouGood’s Current Ratio:
Current Ratio
Times
2
1.19
1.02
1
0.89
0
2002
2003
2004
Years
From our information above you will see that YouGood is well under
the desirable ratio for a small company. It should therefore aim for an
BER, M10Ho1
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Media and Journalism Course
Business and Economic Reporting
increase and then maintain the ratio between 1.5 and 2 for a
manageable level of current liabilities. Any inefficiency in managing
short-term liabilities should be rectified and stronger credit terms
negotiated only after it builds a capability to honourably service its
financial obligations as they fall due.
Internal Liquidity/Working Capital
Working Capital is the difference between current assets and current
liabilities expressed in dollar terms. It shows whether the business
has funds available to meet short-term obligations. It does not take
into account that some current assets are more liquid (in cash form)
than others.
Working Capital as a Percentage of Revenue
Percent
10.0%
5.0%
4.5%
0.3%
0.0%
2002
2003-2.7%
2004
-5.0%
Years
Working Capital
From our example above you can see that YouGood Company is in
trouble and is close to being technically insolvent i.e. the company’s
working capital needs to vastly improve in comparison to the revenue
that it generates.
Quick Ratio / Acid Test
Quick Ratio /Acid Test measures how much liquid assets the
business has to meet short-term obligations. The assets taken into
account are cash, marketable securities and accounts receivables.
Inventory and other short-term assets are ignored. As a general rule
of thumb this ratio should be maintained between 1 and 1.5:1.
Quick Ratio / Acid Test=
BER, M10Ho1
(Cash + Accounts Receivable + Short-term Investments)
Current Liabilities
2
Media and Journalism Course
Business and Economic Reporting
Quick Ratio
Times
1
0.63
1
0.46
0.28
0
2002
2003
2004
Years
Quick/Acid Ratio
Again, it is clearly demonstrated that YouGood company is well under
the desirable ratio in this area.
Cash Ratio
The cash ratio is the total dollar value of cash and marketable
securities divided by current liabilities. For a bank this is the cash
held by the bank as a proportion of deposits in the bank. The cash
ratio measures the extent to which a company can quickly liquidate
assets and cover short-term liabilities. The cash ratio is also called
liquidity ratio or cash asset ratio. The accepted rule of thumb for cash
ratio is to maintain it at between 0.5 and 1:1 as long as excess cash is
not tied up in unproductive accounts such as bank deposits, which
could be returning interest lower than if the funds were to be invested
into the business and earning more.
Cash Ratio
Times
0.5
0.0
0.00
2002
0.01
2003
0.05
2004
-0.5
Years
Cash Ratio
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Media and Journalism Course
Business and Economic Reporting
Here’s YouGood’s Cash Ratio - you can again see a less than desirable
ratio.
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