How to: Rating assessment, the liquidity ratios

The credit rating measures the economic and financial balance of a company. The entity is analyzed from different perspectives, in order to assess its creditworthiness.

In this article we will see the ratio used to evaluate a company’s liquidity, i.e. the ability to convert assets into cash in order to pay short term liabilities (here you find the solvency ratios).

Current ratio and quick ratio

The current ratio measures a company’s ability to meet its short-term obligations and its calculated by comparing current assets to current liabilities.

The current assets include a company's cash resources and those assets that can be converted into cash within a year, ie mainly stocks and receivables.

Current liabilities, on the other hand, are payables due within a year, and include payables to suppliers and payables to banks.

Nevertheless, selling stocks can take lot of time (and not all companies have stocks): the quick ratio calculates the ratio of current assets and current liabilities excluding stocks’ value.

Current ratio should be between 1.5 and 2.5, while quick ratio between 1 and 2. However, any result should be compared with the average values resulting from a sector comparison.

Outcomes in this range suggest current assets and short-term liabilities are balanced and the company is able to easily recover the resources needed to meet its debts. Instead, values above or under this range highlight a risky situation and may reveal that the company lacks in liquidity or has too many receivables.

Cash conversion cycle

The Cash Conversion Cycle measures the timespan between a firm's disbursing and collecting cash. As for current and quick ratio, the outcomes of the cash conversion cycle have to be compared with the average values resulting from a sector comparison.

It can be measured as follows:
Cash conversion cycle = DIO + DSO – DPO

where:

  • DIO (Days Inventory Outstanding) = Inventories / Operating value x 365
  • DSO (Days Sales Outstanding) = Accounts receivable / Operating value x 365
  • DPO (Days Payable Outstanding). = Accounts payable / Operating value x 365

To sum up, liquidity ratios highlight whether a company is balanced or not. The more ratios’ outcomes differ from standard values, the more likely is the risk of a further economic and financial imbalance.

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