Liquidity analysis of a company [Part 1]
By “financial analysis” of a company, it is meant the analysis of the economic & financial behaviors of a company through the study of financial statements. Financial analysis is usually done by ratio analysis and the pillars on which ratio analysis is based are basically five:
– Solvency (ability of a company to pay back its debts in the medium to long term)
– Profitability (ability of a company to pay off adequately for the capital invested)
– Liquidity (ability of a company to pay back its debts in the short term)
– Interest expense coverage (capacity of one business to meet its financial expenses with the margins created especially by the main operations)
– Durability (ability of an entity to endure over time thanks to its adaptability and flexibility).
Although “Solvency” still constitutes the main element of the analysis of one company (and then assigning a rating), the recent financial crisis and the credit crunch, have increased the importance of “Liquidity” and its weight in the analysis .
What does evaluating the liquidity of a company mean? The methods proposed in the literature are many but the most recommended one is to compare current assets with current liabilities. What does this mean? Simple: to check one company’s ability to meet its short term financial obligations (suppliers, short-term loans, etc..) thanks to already available liquidity or that will occur in the short term through the collection of the receivables and the sales of the inventories.
Ok, words have been nice so far; but how can we calculate the liquidity? Usually we use two indicators:
– Current ratio = (Current assets) / (Current liabilities)
– Quick ratio = (Current assets – Inventories) / (Current liabilities)
Basically, we are talking about comparing green part with red part of the following graph:
The literature usually suggests considered optimal values for the two indices and these are:
– Current ratio : it must be within the range 1.5 – 2.5;
– Quick ratio : must be greater than 1 but less than 2 .
In fact these values ( however they are good ) are only indicative as they depend heavily on the sector in which the company operates .
In the next part (Part 2) find out why the study of Current and Quick Ratios is not enough to understand whether a company is liquid.