Liquidity ratios are a group of ratios used to measure the ability of a business operation to meets its current obligations. Liquidity ratios are similar to the initial medical tests a patient receives at a doctor’s visit. Doctors take blood pressure, temperature, and pulse rate. The doctor wants assurance that the primary indicators of health are good. Liquidity ratios are exactly the same. The user wants to know that the basic measurements of a business indicate good health today.
The text book definition of the quick ratio is current assets less inventory, divided by current liabilities. The quick ratio is an ineffective tool for the small business using this definition. The small business owner should use cash divided by current liabilities less current portion of long term debt. It is strictly designed to define the ability to pay your bills right now.
Insolvency refers to the ability to pay bills in a timely manner. It does not mean bankruptcy but long-term insolvency is a underlying factor of bankruptcy. Many owners and/or managers of small business have no idea of how to determine if the company is insolvent or headed towards the inability to meet their day to day obligations.
The current ratio is an inappropriate relationship to use or rely on in small business. The ratio is best suited for large publicly traded organizations. This article explains the basic formula for the current ratio, how to identify the ratio in reading financial statements, its purpose and the many drawbacks for its use with small business.
The college textbook definition of working capital is current assets minus payables and accrued expenses. The term explains the dollar value of flexibility a business operation has to take advantage of immediate opportunities or endure sudden or long-term setbacks. Since it is a balance sheet based formula the value is a function of a moment in time.
There are several business financial attributes required for EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) to work well as a basis for the multiple of earnings method (the method used with the Market Comparable Valuation Approach); see Fair Market Value for a better understanding of the three primary business valuation approaches.
Working capital management is a function of finance whereby management ensures adequate cash is available to meet operational needs over the typical working capital cycle. The underlying elements of working capital management include 1) understanding the different forms of current assets and current liabilities and their corresponding cash cycles; 2) recognizing the relationships of production and sales flow; and 3) planning the inflows and uses (outflows) of cash.
Every business owner needs to know the difference between insolvency and bankruptcy. Often these two terms are misunderstood and improperly used in conversation. You need to know their correct meaning because both are used in civil law and both have different issues to address during the process. In addition, understanding these two terms builds a better comprehensive understanding of financing your business.
The quick ratio is a formula used in business to identify the ability of a business to pay its current liabilities. It is also known as the ‘Acid Test’ formula (ratio). In the large markets this formula is one of the financial industry ratios used to value the stock of a corporation. In the arena of the small business, you should only use this ratio as a means to gauge ability to pay your bills right now.