In this video, we walk through 5 FAR practice questions teaching about calculating liquidity ratios. These questions are from FAR content area 1 on the AICPA CPA exam blueprints: Financial Reporting.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Calculating Liquidity Ratios
Liquidity ratios are essential tools that help assess a company’s ability to meet its short-term obligations. By analyzing liquidity ratios, investors and analysts can gauge a company’s financial flexibility and short-term financial health. In this post, we will break down five critical liquidity ratios: Current Ratio, Quick Ratio (Acid-Test Ratio), Accounts Receivable Turnover, Inventory Turnover, and Accounts Payable Turnover.
Current Ratio = Current Assets / Current Liabilities
Purpose:
The current ratio measures a company’s ability to cover its short-term obligations using its current assets. This ratio reflects how well a company can pay its debts over the next 12 months. A higher current ratio suggests a stronger liquidity position, indicating that the company has more assets to cover its liabilities.
Example:
Imagine XYZ Corp. has current assets totaling $500,000 and current liabilities of $300,000.
Current Ratio = 500,000 / 300,000 = 1.67
This means that for every dollar of liability, XYZ Corp. has $1.67 in current assets, demonstrating a solid liquidity position.
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
Purpose:
Also known as the acid-test ratio, the quick ratio provides a stricter measure of liquidity by excluding inventory and prepaid expenses. It focuses on the company’s most liquid assets, giving a more immediate sense of its ability to meet short-term liabilities without relying on inventory sales.
Example:
ABC Inc. has cash of $100,000, accounts receivable of $150,000, marketable securities of $50,000, and current liabilities of $250,000.
Quick Ratio = (100,000 + 50,000 + 150,000) / 250,000 = 1.20
This means that ABC Inc. has $1.20 in its most liquid assets for every dollar of current liabilities, indicating solid short-term liquidity.
Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
Purpose:
This ratio measures how efficiently a company collects its receivables from customers. A higher accounts receivable turnover ratio indicates that the company is efficient at converting credit sales into cash, meaning it collects payments from customers more frequently during the year.
Example:
Consider DEF Co., which has net credit sales of $900,000. The company had beginning accounts receivable of $80,000 and ending accounts receivable of $120,000.
Average Accounts Receivable = (80,000 + 120,000) / 2 = 100,000
Accounts Receivable Turnover = 900,000 / 100,000 = 9
This means that DEF Co. collected its average receivables 9 times during the year, indicating efficient collections.
Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory
Purpose:
The inventory turnover ratio measures how efficiently a company manages its inventory. A higher inventory turnover ratio indicates that the company is selling and replenishing its inventory more frequently, which is generally positive as it means the company avoids overstocking and reduces holding costs.
Example:
GHI Ltd. reports a cost of goods sold (COGS) of $750,000. It had beginning inventory of $100,000 and ending inventory of $150,000.
Average Inventory = (100,000 + 150,000) / 2 = 125,000
Inventory Turnover = 750,000 / 125,000 = 6
This means that GHI Ltd. turned over its inventory 6 times during the year, indicating effective inventory management.
Accounts Payable Turnover = Total Purchases (or COGS) / Average Accounts Payable
Purpose:
The accounts payable turnover ratio measures how quickly a company pays off its suppliers. A higher ratio indicates that the company is paying its creditors more frequently, which may suggest strong cash management. Conversely, a lower ratio could indicate slower payments or cash flow issues. If purchases information is not available, COGS is often used instead.
Example:
JKL Corporation has total purchases of $600,000. The company had beginning accounts payable of $50,000 and ending accounts payable of $70,000.
Average Accounts Payable = (50,000 + 70,000) / 2 = 60,000
Accounts Payable Turnover = 600,000 / 60,000 = 10
This means that JKL Corporation paid off its accounts payable 10 times during the year, reflecting strong payment practices.
Conclusion
Each liquidity ratio serves a unique role in evaluating a company’s ability to meet its short-term obligations. The current ratio and quick ratio assess overall liquidity and the ability to cover liabilities with current or liquid assets. The accounts receivable turnover ratio shows how efficiently a company collects payments, while the inventory turnover ratio assesses inventory management. Lastly, the accounts payable turnover ratio reflects how quickly a company pays off its suppliers. Together, these ratios offer valuable insights into a company’s short-term financial health and operational efficiency. Understanding and applying these ratios can help analysts and investors make informed decisions about a company’s ability to meet its immediate financial obligations.
