In liquidity ratio analysis there are two types of ratios:
- Current Ratio
- Quick (Acid-Test) Ratio.
Current Ratio
Current Ratio shows how many $1 of current assets are available for paying $1 of current liabilities of the company, firm or organization. As some financial analysts suggests that the more current assets that are available to the company, the better. But in some cases, a high current ratio may indicate too much inventory or too much in prepaid or other current assets. It could also indicate idle cash, and as a result, a poor investment strategy. A current ratio that is high is not as bad as one that is low, however a high current ratio is an indication that financial policies either do not exist or are not being implemented. A low or declining current ratio is always bad. It is an indicator of rising current liabilities and declining current assets. A current ratio of 1 or less is an indication of insolvency. Further declines in the ratio could trigger collection actions on the part of creditors and send the company into bankruptcy.
Quick (Acid-Test) Ratio
The quick ratio is calculated by dividing cash by current liabilities. This is the true test of a companies ability to pay its debts. A high current ratio and a low quick ratio could indicate too much is invested in inventory or other current assets, assets that are not very liquid and therefore could not be depended on to pay current liabilities. An increase in inventory could be a signal that sales have fallen, production has slowed and management should take action to prevent any damage to the financial condition of the company. Both ratios should be analyzed together to get the correct picture of the companies financial health.
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