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Financial Statement Liquidity and Activity Ratios: What Do They Tell You?

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What do liquidity and activity ratios tell managers? How should they be interpreted and used?

Managers are often confronted with operational vis-à-vis financing problems that heavily require informed decision-making activities. Even a seasoned top management may encounter pitfalls brought about by poor financial statements and portfolio analyses. On the other hand, a newly promoted management trainee may prove equally competitive skills when it comes to rational decision-making partly or solely based on proper analyses of financial statement key ratios.

Liquidity Ratios

Liquidity ratios measure the company’s ability to satisfy shortly maturing commitments. Much insight can be obtained from these ratios about the company’s cash solvency at present as well as its ability to remain solvent amidst adversity.

The current ratio is one of the most frequently used liquidity ratios. It is computed by dividing the current assets by the current liabilities. The higher the current ratio, the greater is the company’s ability to pay its operating bills. This measure is more useful however if the bulk of the current assets is concentrated on cash and currently collectible receivables rather on inventories which are obviously non-cash. For this reason, the acid-test ratio might be a better gauge. It takes a more conservative approach to measuring liquidity by excluding inventories from current assets in the current ratio formula. Out of the three most common current assets (cash, receivables, inventories), they are the items that do not quickly turn into cash which can be readily used to settle current payables. They are the least liquid, so to speak. Because of this, acid-test ratio is also called as quick ratio.

Activity Ratios

Also known as efficiency or turnover ratios, activity ratios measure effectiveness of the company in using its resources. Common measures computed are receivable, payable and inventory turnover ratios.

Receivable turnover ratio is arrived at by dividing net credit sales by receivables. To better match the nature of sales and to reflect the movement of receivable balances, average receivable balance is being used. The ratio tells about the quality of the company’s collectibles and how effective the company is in collecting them. A high receivable turnover ratio indicates that company’s credit customers are creditworthy and the collection team is aggressively doing its job. To further the analysis, receivable turnover in days may be computed. Divide the number of days in a year by the turnover rate. The quotient tells managers about the average age of the receivables. It gives insight as to the number of days it takes from the time a sale is made on credit to the time the credit is collected. A low receivable turnover in days indicates effective monitoring and collection.

In the same way, if the company wants to know how effectively it is able to manage its payables, a payable turnover ratio may be computed. Only this time, the variables included are net purchases on credit and average account payables. Also, the payable turnover in days indicates the days it takes from the time a purchase is made on credit to the time the account is settled.

Lastly, the inventory turnover ratio measures effective inventory management. The ratio is computed by setting cost of goods sold or cost of sales as numerator and average inventories as denominator. However, it might be indispensable to compute for a more sophisticated average inventory figure if the company is to factor out a strong seasonal element. The ratio measures the number of times the company’s inventories or items for sale are actually sold during the year. The higher the ratio, the better. It suggests saleability of the items as well as product competitiveness. It also means good trading relationships with distributors, retailers and or end consumers.

1 comment

Romelyn Stephens
Posted on Jun 2, 2011

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