Liquidity Ratios and Activity Ratios

Topics: Financial ratio, Inventory, Financial ratios Pages: 6 (2112 words) Published: October 13, 2010

2 Liquidity Ratios

Liquidity ratios measure a business' capacity to pay its debts as they come due. It also measures the cooperative’s ability to meet short-term obligations. Liquidity refers to the solvency of the firm’s overall financial position – the ease with which it can pay its bills. Because a common precursor to financial distress and bankruptcy is low or declining liquidity, these ratios can provide early signs of cash flow problems and impending business failure. The two basic measures of liquidity are the current ratio and the quick (acid test) ratio (Gitman, 2009).

1. Current ratios

The current ratio is current assets divided by current liabilities. The current ratio measures the firm’s ability to convene its short-term obligations. However, this ratio does not consider the degree of liquidity of each component of current assets. In the other words, if current assets of a cooperative were mainly cash, they would be much more liquid than if comprised of mainly inventory (“Using Financial Ratio Analysis,”1995). Basically, the higher the current ratio, the more liquid is considered to be. If the ratio is less than industry average, current liabilities exceed current assets; it will put the companies liquidity in threatened. Liquidity is actually that in how much time the asset can be converted into cash. Figure 2.1 shows that current ratio for PJV was relatively low for 3 consecutive years from 2007, 2008 and 2009. The current ratio for 2007 was 0.6 and increased to 0.75 in 2008. Although the liquidity rate is growing in case of 2009 to 0.78, it is still below industry average which was stood at 0.84. This is predominantly due to the situation that the company has high current liabilities compared to current asset. The company recorded high current liabilities because they have substantial amount in trade creditor and bank borrowing accounts. Trade creditor recorded at RM 71,566,000 in 2007 and it increased to RM 83,677,000 in 2008. This trade creditor increased resulting from expansion PJV to do to meet their new project secured. However, with the payment made, the trade creditor decreased in 2009 to RM 75,225,000. In addition to the trade creditor, the company has subscribed to financing or borrowings from MIDF and few bankers to finance their activities that include purchasing of raw materials, purchasing of new machineries and overhead to support new projects secured from Perodua & Proton. Besides looking at PJV from times series’ perspective, we have also analyzed the financial ratios using cross sectional analysis method. Cross sectional analysis involves the comparison of different firm’s financial ratios at the same point of time (Gitman, 2009). In year 2009, current ratio for Ingress is 0.68, which is lower than PJV but Sapura has recorded 1.04 of current ratio, higher then PJV and the industry average. 2. Quick Ratios

The acid test ratio is a measure of liquidity designed to overcome the effect of current ratio. It is often referred to as quick ratio because it is a measurement of firm’s ability to convert its current assets quickly into cash in order to meet its current liabilities (Halyal, 2008). It indicates the level to which a company could pay current liabilities without relying on the sale of inventory or in the other word, how quickly the company can pay their bills. In general, the quick ratio should be 1:1 or better. This means that a company has at least a unit’s worth of easily convertible assets for each unit of its current liabilities. A high quick ratio usually reflects a sound, well-managed organization in no danger of imminent collapse, even in the extreme and unlikely event that its sales ceased immediately. On the other hand, companies with ratios of less than 1 could not pay their current liabilities, and should be looked at with extreme care. While a ratio of 1:1 is...
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