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The Forte Newsletter: Financial Planning Tips

 

Calculating Your Liquidity Ratio

Current Ratio

What it is:
The current ratio is the standard measure of any business' financial health. It will tell you whether your business is able to meet its current obligations by measuring if it has enough assets to cover its liabilities. The standard current ratio for a healthy business is two, meaning it has twice as many assets as liabilities.

When to use it:
The current ratio should be part of your business' basic financial planning, meaning it should be tracked monthly or quarterly. By keeping a close eye on this figure, you will recognize if it begins to get out of line. This will allow you to take early action to prevent your business from ending up in a difficult position.

The formula:
Current assets divided by current liabilities.

Quick Ratio

What it is:
Like the current ratio, the quick ratio (also sometimes called the acid test ratio) measures a business' liquidity. However, many financial planners consider it a tougher measure than the current ratio because it excludes inventories when counting assets. It calculates a business' liquid assets in relation to its liabilities. The higher the ratio is, the higher your business' level of liquidity, which usually corresponds to its financial health. The optimal quick ratio is 1 or higher.

When to use it:
This is an important planning tool, especially for businesses that can tie up a lot of assets in inventory. By tracking it monthly, you can keep an eye out for negative trends that could hamper your business' ability to meet its obligations. You can also use the quick ratio to evaluate the financial health of potential customers, since it also indicates whether a business can pay off its debts quickly. A firm with a low quick ratio may be more likely to delay payments because its assets are tied up elsewhere.

Tip: Take control of your business spending by using charge cards which require you to pay your balance in full each month .

The formula:
(Current assets less inventories) divided by current liabilities.

 

 

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