Liquidity RatiosYou have to be in it to win it!Most businesses go bust because they run out of cash. Liquidity ratios will give you some indication of the margin of safety the company is operating with, especially if trended across time. This way, as soon as the liquidity position starts to deteriorate it will receive more focus, and remedying actions can be taken. Unless you can answer "yes", to the question: "Will the business have enough cash to meet the most immediate of it's short term liabilites?", then all other analyses are pointless. In many businesses short term liabilites are often greater than cash in the bank, so one has to consider where the funding will come from to meet these short term liabilities. This is where the concept of the cash flow cycle comes in. Cash is constantly cycling through a business. As a customer pays for something, it enter's the bank, and is then used by the company to pay for supplies, wages etc. By the time the finished goods are in the warehouse, there is a considerable amount of cash tied up in accounts payable.It is not until the products are sold, sales invoices raised, and the cash is received from the customer that the cycle starts all over again. The money tied up in the cash cycle is referred to as working capital, and liquidity formulas aim to measure the balance between current assets (cash tied up that can be released) and current liabilities (purchases already made that must be paid for) The most often used liquidity measures are: Top of Liquidity Ratios More juicy Accounting Formulas More background on Inventory Turnover Ratio Small Business Finance Tips Home Page |