3.1 Liquidity Ratios

Welcome back to Career Readiness. This is the course on finance for non-financial professionals, and this is module three. In module three, we’re gonna be looking at ratios. Ratios can be a lot of fun because they’re quick, they’re easy. And it’s a way to look inside of a business and really start to see how that business is performing, where it’s strong, where it’s weak. We can often I, of often identify opportunities and threats so there’s a lot of correlation between a SWOT analysis and performing ratios. The great thing about ratios also, is that ratios are just that, they’re ratios. Which means we can take a huge business and we can take a very small business, and by running the ratios we’re gonna be getting fractional numbers or percentages. So, we’re gonna be getting the same kind of information, and to see or be able to compare these different business without regard necessarily to their size. And when we see the differences then we can look and say, well because this one is big, or this one is small, we can, we can actually start explaining the ratios a little bit more. Now, before we get on with the ratios, let’s look at what ratios really are. Ratios are quick and dirty, okay, ratios do not take us a lot of time usually. Therefore, with efficiency usually can come reduced accuracy, okay? And ratios are highly efficient, therefore accuracy of a single ratio can often be or can sometimes be minimal, nominal. Okay? So you don’t wanna look at just one ratio. When you wanna run, when you run ratios, you want to run several ratios. You want to spend some time on them. Okay? The, we have a saying in finance, if you torture the numbers long enough, they’re bound to confess. And this is what we’re doing with ratios, we start to torture the numbers. Now, also, you want to be careful, either that you don’t have a, a coerced confession. Torture them too long and they’ll say whatever you want them to say, right? So, again, the great thing about ratios, you’ve got some standard ratios, we run some ratios. And we see what the numbers really tell us. Now, the first classification of ratios that we have, what we call liquidity ratios. What is liquidity? Liquidity is the, the cash available to an institution. How liquid are they? How much cash do they have? And in the liquidity ratio, what we’re concerned with is we want to know how quickly a company can convert what it has, it’s assets, into cash. Because in the end, it’s cash that you’ve got to use to pay your employees. It’s cash you’ve got to use to pay your creditors. Okay. So assets are great, but how quickly you can convert those into cash? We’ve got a few different liquity ratios. In fact there’s many different equity liquidity ratios. I’m just showing you the most common, the most popular. And a great resource for you is the website investopedia.com. I go to investopedia all the time if I want a new ratio, if I’m wondering if there is a ratio I can use that, that’s gonna tell me this or that, or, or different ways to calculate a ratio. We’ve got these ratios but as you’ll see in the course material there’s sometimes, there’s two, or even three different calculations for that ratio. We say well that’s the ratio and this is how we calculate it, but we can also calculate it this way. And we can also calculate it this way. And with each of those calculations, usually we’re adding a bit of complexity and we’re gaining a bit of accuracy. So the first one is called the working capital ratio and basically, it’s showing how much well this one is current assets divided by current liability. So basically it’s looking at how much you currently owe, and how much you currently have, current assets, assets that are gonna be quickly converted into cash. We just make sure that the, the current liabilities, which are the payments we’re gonna have to make in the near future, are able to be covered by our current assets, the money we expect to come in in the near future. So bills that we have sent out that we expect to be paid within 30 days, 60 days, whatever. Those are current, because we, we expect that money coming in. Likewise, the bills that we’ve received that we have to pay within 30 days, 60 days. That, that’s the current liability. So we’re just making sure that what’s coming in is enough to pay what is supposed to be going out. Next one that we’ll talk about is the quick ratio, also known as the acid test. This one is current assets minus inventories, divided by current liabilities. So the same thing that we just looked at with the working capital ratio, except this one takes out our, our inventories, right? Why? Well, because maybe it’s not so easy to turn your inventory into cash. And in the worse case of scenarios when you have outdated or obsolete inventory it can be almost impossible to turn into cash. So this one a little bit, it’s quick and dirty but it’s a little bit more refined. It takes out something and says, okay can these people meet their obligations? As you can see in your course notes there’s even a more a more involved, a, a little bit more complex way to calculate. The quick rate, the quick ratio.