Liquidity ratios are used to measure a firm's ability to meet short-term obligations. The compare short-term obligations with short-term (or current) resources available to meet these obligations. From these ratios, much insight can be obtained into the present cash solvency of the firm and the firm's ability to remain solvent in the event of adversity.
Aldine is engaged in making household electrical appliances. Its current ratio is somewhat above the median ratio for the industry of 2.1. (The median - or middle value - for the industry is taken from the Risk Management Association, Statement Studies.) Although comparisons with industry averages do not always reveal financial strength or weakness, they are meaningful in identifying companies that are out of line. Where a significant deviation occurs, the analyst will want to determine the reasons. Perhaps the industry itself is overly liquid, and the company being examined is basically sound despite a lower current ratio. In another situation, the company being analyzed may be too liquid, relative to the industry, with the result that it forgoes additional profitability. Whenever a financial "red flag" is raised, the analyst must search out the reasons behind it.
Supposedly, the higher the current ratio, the greater the ability of the firm to pay its bills; however, this ratio must be regarded as a crude measure because it does not take into account the liquidity of the individual components of the current assets. A firm having current assets composed principally of cash and nonoverdue receivables is generally regarded as more liquid than a firm whose current assets consist primarily of inventories. Consequently, we turn to a more criticalVpr severe, test of the firm's liquidity - the acid-test ratio.
This ratio serves as a supplement to the current ratio in analyzing liquidity. This ratio is the same as the current ratio except that it excludes inventories - presumably the least liquid portion of current assets - from the numerator. The ratio concentrates primarily on the more liquid current assets - cash, marketable securities, and receivables - in relation to current obligations. Thus this ratio provides a more penetrating measure of liquidity than does the current ratio. Aldine's acid-test ratio is slightly above the industry median average of 1.1, indicating that it is in line with the industry.
Summary of Aldine's Liquidity (So Far). Comparisons of Aldine's current and acid-test ratios with medians for the industry are favorable. However, these ratios don't tell us whether accounts receivable and/or inventor)' might actually be too high. If they are, this should affect our initial favorable impression of the firm's liquidity. Thus we need to go behind the ratios and examine the size, composition, and quality of these two important current assets. We will look more closely at accounts receivable and inventory when we discuss activity ratios. We will reserve a final opinion on liquidity until then.