610 2-1 Discussion- Analytical Tools for the Balance Sheet
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610 2-1 Discussion: Analytical Tools for the Balance Sheet
I’ll be examining liquidity ratios as a tool for balance sheet analysis.
Liquidity ratios indicate a company's ability to meet its currently maturing financial obligations (Wahlen, Jones, Pagach, 2017). There are two common ratios that deal with liquidity, the current ratio and the quick ratio. The current ratio measures whether or not a company has enough assets to pay off their liabilities. A quick ratio measures if a company is
able to pay off short-term liabilities with short-term assets, net receivables, and cash equivalents (Thomas & Tietz, 2021). The current ratio is the most commonly used ratio to evaluate liquidity. It is computed as follows:
Current Ratio = Current Assets ÷ Current Liabilities (Wahlen, et al, 2017).
The usefulness in the current ratio is that it evaluates the relative relationship between assets and liabilities, thus allowing comparisons of liquidity between different companies of different sizes. It is, however, important to keep in mind that some assets can be converted to cash more quickly than others. For example, prepaid expenses cannot, generally, be converted to cash.
The quick ratio includes the quick assets that can be converted into cash within 90 days (typically including cash and cash equivalents, short-term investment securities, and receivables). The quick ratio is computed as follows:
Quick Ratio=Quick Assets ÷ Current Liabilities (Wahlen, et al, 2017).
The quick ratio generally does not include prepaid assets or inventory in its calculation, as there is no quick way to convert these assets into cash and inventory can often be sold on credit. The
analysis of this ratio can reveal when a company is leaning too hard on credit by highlighting their ability (or inability) to pay off current liabilities with cash assets.
References:
Thomas, C. W. & Tiez, W. M. (2021, February 1). Financial accounting. Pearson.
Wahlen, J., Jones, J., Pagach, D.
(2017).
Intermediate Accounting: Reporting And Analysis
(2nd ed. 2017 Update).
United States:
Cengage Learning.
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Match the words to the definitions.
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A forecast of the amount and timing of future cash inflows and outflows over some period of time.
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