Financial Ratios (Liquidity) Flashcards
What is liquidity?
Liquidity is the ability to settle liabilities.
State the formula for current ratio.
Current Assets : Current Liabilities
What is working capital?
Short term resources available to for daily operation. It is the excess of current assets over current liability.
Explain current ratio, 2:1
2:1 indicates for each dollar of short term debts, business has available $2 current assets.
What is the acceptable norm for current ratio?
2:1
Explain current ratio 0.6:1
0.6:1 indicates for each dollar of short term debts, business has available $0.6 current assets. The business has negative working capital.
What is another term for current ratio?
Working capital ratio
What does acid test ratio indicate?
Acid test ratio indicates the ability of business to settle short term debts upon demand / instantly.
State the formula for acid test ratio.
[Current assets - inventory - prepayments] : Current liabilities
A business has current ratio of 2:1. However, its acid test ratio is only 0.4:1.
Explain the discrepancy.
The business has high current ratio but low acid test ratio because it has held too much inventory or made too much prepayments.
Explain acid test ratio 0.8:1
This ratio means for each dollar of short term debt, business has only 80 cents quick assets available. Business may have difficulty paying its short term debts upon demand.
Explain how business can improve its liquidity.
- Increase cash through capital contribution
- Sell non-current asset for cash
- Sell inventory at a profit
What is the acceptable norm for acid-test ratio?
1 : 1
Is a high current ratio better than a low current ratio?
Too high a current ratio means short term resources is not optimally used; too low a current ratio means inability to settle its short term debts.
