Page 158 - CalcBus_Flipbook

20-2 Profitability & Performance Measures CH 20]

dealt with in business are comparisons of values through division. For example, a business
will have current assets, assets that are easily converted to cash or include cash, compared
to current liabilities, claims against those assets. It can be expressed as

Current Assets : Current Liabilities.

At this point we realize that the colon ( : ), though expressing a relationship of one value to
another, can be used to designate division, such that

Current Assets ÷ Current Liabilities

or as a fraction with a numerator and denominator, becomes

Current Assets
Current Liabilities,

all of which express the relationship of Current Assets to Current Liabilities. The
mathematical result is the numerical relationship of some number to 1, as in

12 : 15 = 12 ÷ 15 = 0.8 or more accurately as a ratio 0.8 : 1.

The 1 value is not an arbitrary number. Rather, it is calculated, in that one has to think
what must 15 be divided by so that the result is 1. The answer is to divide 15 by 15 which
will equal (15 ÷ 15 =) 1. As 15 is divided by 15, similarly 12 is divided by 15. As such our
ratio of Current Assets to Current Liabilities is better expressed as

Current Assets Current Liabilities
:
Current Liabilities Current Liabilities

The concluding arithmetic to this is that Current Assets are expressed as a numerical
value in relation to Current Liabilities as if Current Liabilities has a value of 1. This
relationship is true for all division which includes fractions. The dividend is being restated in
terms of the divisor as though the divisor has a value of one. For fractions, the numerator is
being expressed in terms of the denominator as though the denominator has a value of one.
The arithmetic example of this introduction is represented below beginning with the
discussion on Current Ratio and its arithmetic application is employed for the ratios you
will be calculating.

Liquidity
Liquidity ratio: A
financial ratio that Liquidity is that ability to convert assets into cash. Cash is the most liquid asset as it is
indicates whether a already cash. Compared to other assets such as accounts receivable, inventory or
company's current merchandise for sale, or finished goods, these are less liquid as they take time to sell for
assets will be sufficient cash. Prepaid expenses such as unused portions of insurance policies require the
to meet the company's termination of contracts and the refund on the unused portion of those contracts. From this
obligations when they
become due. liquidity also has a time element involved. As such liquidity is how long it takes to convert
an asset to cash.
Long-term Liquidity Ratios. Liquidity ratios analyze a firm’s ability to pay off its current
liabilities (debt): liabilities, working liabilities and fixed liabilities. Both working and fixed liabilities are
Accounts included considered long-term liabilities as they are debts that have terms from 18 months to as great
working liabilities
and fixed liabilities as 50 years. These ratios show the cash levels of a company and its ability to turn other
as long-term assets into cash to pay off debt. Liquidity is a measure of converting non-cash assets to cash
liabilities as their to meet debt obligations.
liquidity is 18 months As cash is already liquid, the measures include other assets such as inventory for sale,
or longer. accounts receivable, and trading securities. As such, assets are included in the liquidity
calculation of a company.
The most common liquidity ratios are:
1. Working Capital
2. Current Ratio
3. Acid Test Ratio/Quick Ratio

Copyrighted Material