Liquidity Ratios

Liquidity ratio analysis measure how liquid the company’s assets are (how easily can the assets be
converted into cash) as compared to its current liabilities. There are three common liquidity ratio

1. Current ratio analysis

2. Acid test (or quick asset) ratio analysis
3. Cash Ratio analysis

#1 – Current Ratio Analysis

WHAT IS CURRENT RATIO ANALYSIS?

Current ratio is the most frequently used ratio to measure company’s liquidity as it is quick, intuitive
and easy measure to understand the relationship between the current assets and current liabilities. It
basically answers this question “How many dollars in current assets does the company have to cover
each $ of current liabilities”

Current Ratio Formula = Current Assets / Current Liabilities

Let us take a simple Current Ratio Calculation example,

Current Assets = $200 Current Liabilities = $100

Current Ratio = $200 / $100 = 2.0x
This implies that the company has two dollar of current assets for every one dollar of current liabilities.
ANALYST INTERPRETATION OF CURRENT RATIO

 Current ratio analysis provides us with a rough estimate that whether the company would be
able to “survive” for one year or not. If Current Assets is greater than Current Liabilities,
we interpret that the company can liquidate its current assets and pay off its current liabilities
and survive at least for one operating cycle.
 Current Ratio analysis in itself does not provide us with full details of the quality of current
assets and whether they are fully realizable.
 If the current assets consists primarily of receivables, we should investigate the collectability of
such receivables.
 If current assets consists of large Inventories, then we should be mindful of the fact that
inventories will take longer to convert into cash as they cannot be readily sold. Inventories are
much less liquid assets than receivables.
 Average maturities of current assets and current liabilities should also be looked into. If current
liabilities mature in the next one month, then current assets providing liquidity in 180 days may
not be of much use.

CURRENT RATIO ANALYSIS – COLGATE CASE STUDY EXAMPLE

Let us now calculate the Current Ratios for Colgate.

  Colgate has maintained a healthy current ratio of greater than 1 in the past 10 years.
 Current ratio of Colgate for 2015 was at 1.24x. This implies that current assets of Colgate are
more than current liabilities of Colgate.
 However, we still need to investigate on the quality and liquidity of Current Assets. We note
that around 45% of current assets in 2015 consists of Inventories and Other Current Assets. This
may affect the liquidity position of Colgate.
 When investigating Colgate’s inventory, we note that majority of the Inventory consists of
Finished Goods (which is better in liquidity than raw materials supplies and work-in-progress).

source: Colgate 2015 10K Report, Pg – 100

Below is a quick comparison of Current Ratio of Colgate’s vs P&G vs Unilever

source: ycharts
  Colgate’s current Ratio as compared to its peer group (P&G and Unilever) appears to be much
better.
 Unilever current ratio seems to be declining over the past 5 years. However, P&G Current
ratio has remained less than 1 in the past 10 years or so.

#2 – Quick Ratio Analysis

WHAT IS QUICK RATIO?

 Sometimes current assets may contain huge amounts of inventory, prepaid expenses etc.
This may skew the current ratio interpretations as these are not very liquid.
 To address this issue, if we consider the only most liquid assets like Cash and Cash
equivalents and Receivables, then it should provide us with a better picture on the coverage of
short term obligations.
 This ratio is know as Quick Ratio or the Acid Test.
 The rule of thumb for a healthy acid test index is 1.0.

Quick Ratio Formula = (Cash and Cash Equivalents + Accounts Receivables)/Current Liabilities

Let us take a simple Quick Ratio Calculation example,

Cash and Cash Equivalents = $100

Accounts Receivables = $500
Current Liabilities = $1000
Then Quick Ratio = ($100 + $500) / $1000 = 0.6x
ANALYST INTERPRETATION

 Accounts Receivables are more liquid than the inventories.

 This is because Receivables directly convert into cash after the credit period, however,
Inventories are first converted to Receivables which in turn take further time to convert into
cash.
 In addition, there can be uncertainty related to the true value of the inventory realized as some
of it may become obsolete, prices may change or it may become damaged.
 It should be noted that a low quick ratio may not always mean liquidity issues for the
company. You may find low quick ratios in businesses that sell on cash basis (for example,
restaurants, supermarkets etc). In these businesses there are no receivables, however, there
maybe a huge pile of inventory.

QUICK RATIO ANALYSIS – COLGATE CASE STUDY EXAMPLE

Let us now look at the Quick Ratio calculations in Colgate.

Quick Ratio of Colgate is relatively healthy (between 0.56x – 0.73x). This acid test shows us the
company’s ability to pay off short term liabilities using Receivables and Cash & Cash Equivalents.
Below is a quick comparison of Quick Ratio analysis of Colgate’s vs P&G vs Unilever

source: ycharts
As compared to its Peers, Colgate has a very healthy quick ratio.
While, Unilever’s Quick Ratio has been declining for the past 5-6 years, we also note that P&G Quick
ratio is much lower than that of Colgate.

#3 – Cash Ratio analysis

WHAT IS CASH RATIO ANALYSIS?

Cash ratio considers only the Cash and Cash Equivalents (there are the most liquid assets within the
Current Assets). If the company has a higher cash ratio, it is more likely to be able to pay its short term
liabilities.

Cash Ratio Formula = Cash & Cash equivalents / Current Liabilities

Let us take a simple Cash Ratio Calculation example,

Cash and Cash Equivalents = $500

Current Liabilities = $1000
Then Quick Ratio = $500 / $1000 = 0.5
ANALYST INTERPRETATION

 All three ratios – Current Ratios, Quick Ratios, and Cash Ratios should be looked at for
understanding the complete picture on Company’s liquidity position.
 Cash Ratio analysis is the ultimate liquidity test. If this number is large, we can obviously
assume that the company has enough cash in its bank to pay off its short term liabilities.

CASH RATIO – COLGATE CASE STUDY EXAMPLE

Let us calculate Cash Ratios in Colgate.

Colgate has been maintaining a healthy cash ratio of 0.1x to 0.28x in the past 10 years. With this higher
cash ratio, the company is in a better position to payoff its current liabilities.
Below is a quick comparison of Cash Ratio of Colgate’s vs P&G vs Unilever

source: ycharts
Colgate’s Cash ratio as compared to its peers seems to be much superior.
Unilever’s Cash Ratio has been declining in the past 5-6 years.
P&G cash ratio has steadily improved over the past 3-4 years period.

TURNOVER RATIO ANALYSIS OF FINANCIAL STATEMENT

We saw from the above three liquidity ratios (Current, Quick and Cash Ratios) that it answer the
question “Whether the company has enough liquid assets to square off its current liabilities”. So this
ratio is all about the $ amounts.

However, when we look at Turnover ratio analysis, we try to analyze the liquidity from “how long it will
take for the firm to convert inventory and receivables into cash or time taken to pay its suppliers”

The commonly used turnover ratios include:

 4) Receivables turnover
 5) Accounts receivables days
 6) Inventory turnover
 7) Inventory days
  8) Payables turnover
 9) Payable days
 10) Cash Conversion Cycle

#4 – Receivables Turnover Ratio analysis

WHAT IS RECEIVABLES TURNOVER RATIO ANALYSIS?

 Accounts Receivables Turnover Ratio can be calculated by dividing Credit Sales by Accounts
Receivables.
 Intuitively. it provides us the number of times Accounts Receivables (Credit Sales) is converted
into Cash Sales
 Accounts Receivables can be calculated for the full year or for a specific quarter.
 For calculating accounts receivables for a quarter, one should take annualized sales in the
numerator.

Receivables Turnover Formula = Credit Sales / Accounts Receivables

Let us take a simple Receivables Turnover Calculation example,

Sales = $1000
Credit given is 80%
Accounts Receivables = $200
Credit Sales = 80% of $1000 = $800
Accounts Receivables Turnover = $800 / $200 = 4.0x
ANALYST INTERPRETATION

 Please note that the Total Sales include Cash Sales + Credit Sales. Only Credit Sales convert to
Accounts Receivables, hence, we should only take Credit Sales.
 If a company sells most of its items on Cash Basis, then there will be No Credit Sales.
 Credit Sales figures may not be directly available in the annual report. You may have to dig into
the Management discussions to understand this number.
 If it is still hard to find the percentage of credit sales, then do have a look at conference calls
where analysts question the management on relevant business variables. Sometimes it is not
available at all.

ACCOUNTS RECEIVABLES – COLGATE EXAMPLE

 To calculate the receivables turnover, we have considered average receivables. We consider the
“average” figures as these are balance sheet items.
 For eg. as shown in the image below, we took the average receivables of 2014 and 2015.
 Also, please note that I have taken the assumption that 100% of Colgate’s Sales were “Credit
Sales”.

 We note that the Receivables Turnover was less than 10x in 2008-2010. However, it improved
significantly in the past 8 years and is was closer to 11x in 2015.
  Higher Receivables Turnover implies higher frequency of converting receivables into cash (this
is good!)

Below is a quick comparison of Receivables turnover of Colgate vs P&G vs Unilever

 We note that P&G Receivable turnover ratio is slightly higher than Colgate.
 Unilever’s Receivables turnover is closer to that of Colgate.

source: ycharts

#5 – Days Receivables
WHAT IS DAYS RECEIVABLES?

Days receivables is directly linked with the Accounts Receivables Turnover. Days receivables
expresses the same information but in terms of number of days in a year. This provides with a intuitive
measure of Receivables Collection Days
You may calculate Account Receivable days based on the year end balance sheet numbers.
Many analysts, however, prefer to use the average balance sheet receivables number to calculate the
average collection period. (right way is to use the average balance sheet)
Accounts Receivables Days Formula = Number of Days in Year / Accounts Receivables Turnover

Let us take the previous example and find out the Days Receivables

Let us take a simple Days Receivables Calculation example,

Accounts Receivables Turnover = 4.0x

Number of days in a year = 365
Days Receivables = 365 / 4.0x = 91.25 days ~ 91 days
This implies that it takes 91 days for the company to convert Receivables into Cash.

ANALYST INTERPRETATION

 Number of days taken by most analysts is 365, however, some analyst also use 360 as the
number of days in the year. This is normally done to simplify the calculations.
 Accounts receivable days should be compared with the average credit period offered by the
company. For example in the above case, if the Credit Period offered by the company is 120
days and they are receiving cash in just 91 days, this implies that the company is doing well to
collect its receivables.
 However, if the credit period offered is say 60 days, then you may find significant amount of
previous accounts receivables on the balance sheet, which obviously is not good from
company’s point of view.
DAYS RECEIVABLES – COLGATE CASE STUDY EXAMPLE

 Let’s calculate Days Receivables for Colgate. To calculate Days Receivables, we have taken 365
days assumption.
 Since, we had already calculated receivables turnover above, we can easily calculate the days
receivables now.

Days receivables or Average Receivables collection days has decreased from around 40 days in
2008 to 34 days in 2015.
 This means that Colgate is doing a better job in collecting its receivables. They may have started
implementing a stricter credit policy.

#6 – Inventory Turnover Ratio analysis

WHAT IS INVENTORY TURNOVER RATIO ANALYSIS?

Inventory Ratio means how many times the inventories are restored during the year. It can be
calculated by taking Cost of Goods Sold and dividing by Inventory.Inventory Turnover Formula = Cost of
Goods Sold / Inventory

Let us take a simple Inventory Turnover Ratio Calculation example.

Cost of Goods Sold = $500

Inventory = $100
Inventory Turnover Ratio = $500 / $100 = 5.0x
This implies that during the year, inventory is used up 5 times and is restored to its original levels.

ANALYST INTERPRETATION

You may note that when we calculate receivables turnover, we took Sales (Credit Sales), however, in
inventory turnover ratio, we took Cost of Goods Sold. Why?

The reason is that when we think about receivables, it directly comes from Sales made on the credit
basis. However, Cost of Goods sold is directly related to inventory and is carried on the balance sheet
at cost.

To get an intuitive understanding of this, you may see the BASE equation.

B+A=S+E

B = Beginning Inventory

A = Addition to Inventory (purchases during the year)

S = Cost of Goods sold

E = Ending Inventory

S =B+A–E
As we note from the above equation, Inventory is directly related to Cost of Goods Sold.

INVENTORY TURNOVER RATIO – COLGATE CASE STUDY EXAMPLE

 Let us calculate Inventory Turnover Ratio of Colgate. Like in receivables turnover, we take the
average inventory for calculating Inventory Turnovers.
 Colgate’s inventory consists of Raw material and supplies, work in progress and finished goods.

 Colgate’s inventory turnover has been in the range of 5x-6x.

 In the last 3 years, Colgate has seen a lower inventory turnover ratio. This means that Colgate is
taking longer to process its inventory to finished goods.
#7 – Days Inventory

WHAT IS DAYS INVENTORY?

We calculated Inventory Turnover Ratio earlier. However, most analyst prefer calculating inventory
days. This is obviously the same information but more intuitive. Think of Inventory Days as the
approximate number of days it takes for inventory to convert into finished product.

Inventory Days Formula = Number of days in a year / Inventory Turnover.

Let us take a simple Days Inventory Calculation example. We will use the previous example of
Inventory Turnover Ratio and calculate Inventory Days.

Cost of Goods Sold = $500

Inventory = $100
Inventory Turnover Ratio = $500 / $100 = 5.0x
Inventory Days = 365/5 = 73 days.
This implies that Inventory is used up every 73 days on an average and is restored to its original levels.
ANALYST INTERPRETATION

 You may also think of inventory days as the number of days a company can continue with
production without replenishing its inventory.
 One should also look at the seasonality patter in how inventory is consumed depending on the
demand. It is rare that inventory is consumed constantly throughout the year.

INVENTORY DAYS – COLGATE CASE STUDY EXAMPLE

Let us calculate the Inventory turnover days for Colgate. Inventory Days for Colgate = 365 / Inventory
Turnover.

 We see that inventory processing period has increased from 64.5 days in 2008 to around 70.5
days in 2015.
 This implies that Colgate is processing its inventory a bit slowly as compared to 2008.
#8 – Accounts Payable Turnover

WHAT IS ACCOUNTS PAYABLE TURNOVER?

Payables turnover indicates the number of times that payables are rotated during the period. It is best
measured against purchases, since purchases generate accounts payable.

Payables Turnover Formula = Purchases / Accounts Payables

Let us take a simple Accounts Payable Turnover calculation example. From the Balance Sheet, you are
provided with the following –

Ending Inventory = $500

Beginning Inventory = $200
Cost of Goods Sold = $500
Accounts Payable = $200
In this example, we need to first find out Purchases during the year. If you remember the BASE
equation that we used earlier, we can easily find purchases.
B+A=S+E
B = Beginning Inventory
A = Additions or Purchases during the year
S = COGS
E = Ending Inventory
we get, A = S + E – B
Purchases or A = $500 + $500 – $200 = $800
Payables Turnover = $800 / $200 = 4.0x
ANALYST INTERPRETATION

 Some analysts make a mistake of taking Cost of Goods Sold in the numerator of this accounts
payable turnover formula.
 It is important to note here that Purchase is the one that leads to Payables.
 We earlier saw Sales can be Cash Sales and Credit sales. Likewise, Purchases can be Cash
Purchases as well Credit Purchases. Cash Purchases does not results in payables, it is only the
Credit Purchases that leads to Accounts payables.
 Ideally, we should seek for Credit Purchases information from the annual report.

ACCOUNTS PAYABLE TURNOVER – COLGATE CASE STUDY EXAMPLE

In Colgate’s case study, we first find the Purchases. Purchases 2015 = COGS 2015 + Inventory 2015 –
Inventory 2014

Once we have the purchases, we can now find the payables turnover. Please note that we use the
average accounts payable to calculate the ratio.
We note that Payable turnover has decreased to 5.50x in 2015. This implies that Colgate is taking a bit
longer to make payment to its suppliers.

#9 – Days Payable Ratio Analysis

WHAT IS DAYS PAYABLE RATIO ANALYSIS?

Like with all the other turnover ratios, most analyst prefer to calculate much intuitive Days payable.
Payable days represent the average number of days a company takes to make the payment to its
suppliers.

Payables Days Formula = Number of Days in a year / Payables Turnover

Let’s take a simple Payable Days calculation example. We will use the previous example of Accounts
Payable Turnover to find the Payable days

We earlier calculated Accounts Payable Turnover as 4.0x

Payable Days = 365 / 4 = 91.25 ~ 91 days
This implies that the company pays its clients every 91 days.

ANALYST INTERPRETATION

 Higher the accounts payable days, better it is for the company from liquidity point of view.
 Payable days can be affected by seasonality in the business. Sometimes business may stock
inventories due to upcoming business cycle. This may distort the interpretations that we make
on payable days if we are not aware of seasonality.

ACCOUNTS PAYABLE RATIO ANALYSIS – COLGATE CASE STUDY EXAMPLE

Let us calculate Accounts Payable for Colgate. Since, we have already calculated the Payables Turnover,
we can calculate Payable days = 365/Payables Turnover.

Payable days have been constant at around 66 days for the past 3 years. This means that Colgate takes
around 66 days for paying its suppliers.

#10 – Cash Conversion Cycle

WHAT IS CASH CONVERSION CYCLE?

Cash conversion cycle is the total time taken by the firm to convert its cash outflows into cash inflows
(returns). Think of Cash Conversion Cycle as time taken by a company to purchase the raw materials,
then convert inventory into finished product and sell the product and receive cash and then make the
necessary payout for the purchases.
Cash Conversion cycle depends primarily on three variables – Receivable Days, Inventory Days and
Payable Days.
Cash Conversion Cycle Formula = Receivable Days + Inventory Days – Payable Days

Let us take a simple Cash Conversion Cycle calculation example,

Receivable Days = 100 days

Inventory Days = 60 days
Payable Days = 30 days
Cash conversion cycle = 100 + 60 – 30 = 130 days.
ANALYST INTERPRETATION OF CASH CONVERSION

 It signifies the number of days firm’s cash is stuck in the operations of the business.
 Higher cash conversion cycle means that it takes longer time for the firm to generate cash
returns.
 However, a lower cash conversion cycle may be viewed as a healthy company.
 Also, one should compare the cash conversion cycle with the industry averages so that we are
in a better position to comment on higher/lower side of cash conversion cycle.

CASH CONVERSION CYCLE – COLGATE CASE STUDY EXAMPLE

 Cash Conversion Cycle of colgate = Receivable Days + Inventory Days – Payable Days
 Overall, we note that the cash collection cycle has decreased from around 46 days in 2008 to 38
days in 2015.
 This implies that overall Colgate is improving its cash conversion cycle with each year.
 We note that the receivables collection period has decreased overall that has contributed to
the decrease in cash conversion cycle.
 Additionally, we also note that the average payable days has increased, which again positively
contributed to the cash conversion cycle.
 However, the increase in inventory processing days in the recent years has negatively affected
its cash conversion cycle.
RATIO ANALYSIS OF FINANCIAL STATEMENT – OPERATING PERFORMANCE

Operating performance ratios try and measure how the business is performing at the ground level and
is sufficiency generating returns relative to the assets deployed.

Operating Performance Ratios are two sub-divided as per the diagram below

OPERATING EFFICIENCY RATIOS

#11 – Asset Turnover Ratio analysis

What is Asset Turnover Ratio analysis?

The asset turnover ratio is a comparison of sales to total assets. This ratio provides with an indication
on how efficiently the assets are being utilized to generate sales.

Asset Turnover ratio Formula = Total Sales / Assets

Let us take a simple Cash Conversion Cycle calculation example.

Sales of Company A = $900 million

Total Assets = $1.8 billion
Asset Turnover = $900/$1800 = 0.5x
This implies that for every $1 of assets, the company is generating $0.5

ANALYST INTERPRETATION

 Asset turnovers can be extremely low or very high depending on the Industry they operate in.
 Asset turnover of Manufacturing firm will be on the lower side due to large asset base as
compared to a companies that operates in the services sector (lower assets).
 If the firm has seen considerable growth in assets during the year or the growth has been
seasonal, then the analyst should find additional information to interpret such numbers.

ASSET TURNOVER RATIO ANALYSIS – COLGATE CASE STUDY EXAMPLE

Asset Turnover of Colgate = Sales / Average Assets

We note that the Asset Turnover for Colgate is showing a declining trend. Asset turnover was at 1.53x
in 2008, however, each year this ratio has sequentially decreased (1.26x in 2015).
#17 – Return on Total Assets

WHAT IS RETURN ON TOTAL ASSETS?

Return on Assets or Return on Total Assets relates to the firm’s earnings to all capital invested in the
business.

Two important things to note there –

 Please note that in the denominator, we have Total Assets which basically takes care of both
the Debt and Equity Holders.
 Likewise in the numerator, the Earnings should reflect something that is before the payment of
interest.

Return on Total Asset Formula = EBIT / Total Assets.

Let us take a simple Return on Total example,

Company A has an EBIT of $500 and Total Assets = $2000

Return on Total Assets = $500/$2000 = 25%
This implies that the company is generating a Return on Total Assets of 25%.

ANALYST INTERPRETATION

 Many analysts use the numerator as Net Income + Interest Expenses instead of EBIT. They
basically are deducting the taxes.
  Return on Assets can be low or high depending on the type of industry. If the company
operates in a capital intensive sector (Asset heavy), then the return on assets may be on the
lower side. However, if the company is Asset Light (services or internet company), they tend to
have have a higher Return on Assets.

RETURN ON TOTAL ASSETS – COLGATE’S CASE STUDY EXAMPLE

Let us now calculate the Return on total Assets of Colgate. Colgate’s Return On Total Assets = EBIT /
Average total assets

Colgate’s Return on total assets have been declining since 2010. Most recently, it has declined to its
lowest to 21.9%. Why?
Let’s investigate….
Two reasons can contribute to decrease – either the denominator i.e. average assets have increased
significantly or the Numerator Net Sales have dropped significantly.
In Colgate’s case, the total assets have infact decreased in 2015. This leaves us to look at the Net Sales
figure.
We note that the overall Net sales has decreased by as much as 7% in 2015.

We note that the primary reason for sales decrease for the negative impact due to foreign exchange of
11.5%.
Organic sales of colgate has however increased by 5% in 2015.