Lesson 4 of 8 · 13 min
Liquidity ratios and the cash conversion cycle
Liquidity ratios test whether a company can meet its short-term obligations, from the broad current ratio down to the strict cash ratio, while the cash conversion cycle shows how long cash is tied up in operations.
In short
- Liquidity ratios describe a point in time, so they use ending balance sheet figures, not averages.
- Current ratio = current assets ÷ current liabilities; quick ratio = (cash + short-term marketable investments + receivables) ÷ current liabilities; cash ratio = (cash + short-term marketable investments) ÷ current liabilities.
- Defensive interval ratio = quick assets ÷ daily cash expenditures: days the company could keep paying expenses with no cash coming in.
- Cash conversion cycle = DOH + DSO − days of payables. Shorter means greater liquidity.
- A very negative cash conversion cycle is not automatically good: it can mean the company simply cannot pay its suppliers.
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