Financial ratios are a valuable and easy way to interpret the numbers found in statements. It can help to answer critical questions such as whether the business is carrying excess debt or inventory, whether customers are paying according to terms, whether the operating expenses are too high and whether the company assets are being used properly to generate income.
When computing financial relationships, a good indication of the company's financial strengths and weaknesses becomes clear. Examining these ratios over time provides some insight as to how effectively the business is being operated.
Liquidity measures a company's capacity to pay its debts as they come due. Liquidity Ratios help us understand if we can meet our obligations over the short-run. Higher liquidity levels indicate that we can easily meet our current obligations. We can use several types of ratios to monitor liquidity.
The current ratio gauges how capable a business is in paying current liabilities by using current assets only. Current ratio is also called the working capital ratio. A general rule of thumb for the current ratio is 2 to 1 (or 2:1 or 2/1). However, an industry average may be a better standard than this rule of thumb. The actual quality and management of assets must also be considered. Current Ratio is simply current assets divided by current liabilities. Current assets include cash, accounts receivable, marketable securities, inventories, and prepaid items. Current liabilities include accounts payable, notes payable, salaries payable, taxes payable, current maturities of long-term obligations and other current accruals. A low current ratio would imply possible insolvency problems. A very high current ratio might imply that management is not investing idle assets productively.
Acid Test or Quick Ratio...