CFA Level 1

AAA

Financial Ratios - Internal Liquidity Ratios

1. Current Ratio
This ratio is a measure of the ability of a firm to meet its short-term obligations. In general, a ratio of 2 to 3 is usually considered good. Too small a ratio indicates that there is some potential difficulty in covering obligations. A high ratio may indicate that the firm has too many assets tied up in current assets and is not making efficient use to them.

Formula 7.3

Current ratio = current assets
current liabilities

2. Quick Ratio
The quick (or acid-test) ratio is a more stringent measure of liquidity. Only liquid assets are taken into account. Inventory and other assets are excluded, as they may be difficult to dispose of.

Formula 7.4

Quick ratio = (cash+ marketable securities + accounts receivables)
current liabilities

3. Cash Ratio
The cash ratio reveals how must cash and marketable securities the company has on hand to pay off its current obligations.

Formula 7.5

Cash ratio = (cash + marketable securities)
current liabilities

4. Cash Flow from Operations Ratio
Poor receivables or inventory-turnover limits can dilute the information provided by the current and quick ratios. This ratio provides a better indicator of a company's ability to pay its short-term liabilities with the cash it produces from current operations.

Formula 7.6

Cash flow from operations ratio = cash flow from operations
current liability

5. Receivable Turnover Ratio
This ratio provides an indicator of the effectiveness of a company's credit policy. The high receivable turnover will indicate that the company collects its dues from its customers quickly. If this ratio is too high compared to the industry, this may indicate that the company does not offer its clients a long enough credit facility, and as a result may be losing sales. A decreasing receivable-turnover ratio may indicate that the company is having difficulties collecting cash from customers, and may be a sign that sales are perhaps overstated.

Formula 7.7

Receivable turnover = net annual sales
average receivables

Where:
Average receivables = (previously reported account receivable + current account receivables)/2

6. Average Number of Days Receivables Outstanding (Average Collection Period)

This ratio provides the same information as receivable turnover except that it indicates it as number of days.

Formula 7.8

Average number of days receivables outstanding = 365 days_
receivables turnover

7. Inventory Turnover Ratio
This ratio provides an indication of how efficiently the company's inventory is utilized by management. A high inventory ratio is an indicator that the company sells its inventory rapidly and that the inventory does not languish, which may mean there is less risk that the inventory reported has decreased in value. Too high a ratio could indicate a level of inventory that is too low, perhaps resulting in frequent shortages of stock and the potential of losing customers. It could also indicate inadequate production levels for meeting customer demand.

Formula 7.9

Inventory turnover = cost of goods sold
average inventory

Where:
Average inventory = (previously reported inventory + current inventory)/2

8. Average Number of Days in Stock
This ratio provides the same information as inventory turnover except that it indicates it as number of days.

Formula 7.10

Average number of days in stock = 365
inventory turnover

9. Payable Turnover Ratio
This ratio will indicate how much credit the company uses from its suppliers. Note that this ratio is very useful in credit checks of firms applying for credit. Payable turnover that is too small may negatively affect a company's credit rating.

Formula 7.11

Payable turnover = Annual purchases
Average payables

Where:
Annual purchases = cost of goods sold + ending inventory - beginning inventory
Average payables = (previously reported accounts payable + current accounts payable) / 2

10. Average Number of Days Payables Outstanding (Average Age of Payables)
This ratio provides the same information as payable turnover except that it indicates it by number of days.

Formula 7.12

Average number of days payables outstanding = 365_____
payable turnover

II. Other Internal-Liquidity Ratios

11. Cash Conversion Cycle
This ratio will indicate how much time it takes for the company to convert collection or their investment into cash. A high conversion cycle indicates that the company has a large amount of money invested in sales in process.

Formula 7.13

Cash conversion cycle = average collection period + average number of days in stock - average age of payables

Cash conversion cycle = average collection period + average number of days in stock - average age of payables

12. Defensive Interval
This measure is essentially a worst-case scenario that estimates how many days the company has to maintain its current operations without any additional sales.

Formula 7.14

Defensive interval = 365 * (cash + marketable securities + accounts receivable)
projected expenditures

Where:
Projected expenditures = projected outflow needed to operate the company

Operating Profitability Ratios
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