A controller sees current ratio at 2.1 and declares the firm liquid. The CFO asks how much of those current assets is slow-moving inventory and whether trade payables are due next week. Ratios only mean something in pairs, in trend, and against a benchmark.
Liquidity asks whether current assets can cover current liabilities. Five ratios, increasingly strict:
- Current ratio = Current Assets / Current Liabilities. Above 1.0 is the floor; 1.5 to 2.0 is typical.
- Quick (acid-test) ratio = (Cash + Marketable Securities + AR) / Current Liabilities. Drops inventory and prepaids.
- Cash ratio = (Cash + Marketable Securities) / Current Liabilities. Strictest stock measure.
- Cash flow ratio = Operating Cash Flow / Current Liabilities. Flow-based; tests whether operations alone clear current obligations.
- Net working capital ratio = (CA − CL) / Total Assets. Scales the cushion to firm size.
KEY: Selling $100 of inventory for $120 cash always raises the quick ratio because inventory was excluded. It raises the current ratio only if the firm was already above 1.0.
Common mistakes
- Using ending balances instead of averages for turnover and return ratios. ROA, ROE, and the turnover family use average balance-sheet figures because the numerator is a flow.
- Forgetting the numerator add-back in fixed charge coverage. Lease payments and pre-tax sinking-fund equivalents go in the denominator; only lease payments go back into the numerator.
- Treating the current ratio as direction-neutral. Paying down a current liability with cash raises current ratio if it was already above 1.0 and lowers it if below 1.0. Quick ratio follows the same anchor rule for non-inventory items.
Bottom line
- Liquidity is paying bills due within a year (12-month horizon). Solvency is surviving the long-term debt load and capital structure.
- Cash conversion cycle = DSI + DSO − DPO. Shorter frees working capital.
- DuPont ROE = Net Margin × Asset Turnover × Equity Multiplier (Total Assets / Total Equity), the leverage lever.
- TIE = EBIT / Interest. Fixed charge coverage adds lease payments to both numerator and denominator (pre-tax sinking fund goes in the denominator only).
Exam shortcut
When asked how a transaction affects the current ratio, anchor to 1.0. Above 1.0, equal cash-for-CL payments raise the ratio; below 1.0, they lower it. Same logic for quick ratio with non-inventory items. For a debt-for-equity swap, the equity multiplier and D/E both rise and TIE falls. Compute new interest = old interest + (new debt × rate), then reapply EBIT/Interest.
The full lesson (about 1,911 words, 13 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2A2
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