Short-term debt-paying ability

Many companies follow an operating cycle whereby production inputs are obtained and converted into finished goods, which are then sold and converted to cash.  This requires investment in working capital, which means funds needed to finance inventories and accounts receivable. 

At any point in time, the company will attain a net working capital position.  This is the excess of current assets over current liabilities, and is measured by current ratio.  A positive 'current ratio' usually indicates a company has sufficient available assets to pay its immediate debts.  Of course, the greater the excess (the more the ratio exceeds 1.0), the better the the company is able to satisfy current debts.  However, this is somewhat of a simplistic view, in that, current assets will differ in terms of both valuation and liquidity, and these aspects will affect a company's ability to meet its current obligations.  Thus, a 'quick ratio' which eliminates inventories from the computation, is often used.  Also, a 'cash ratio' is used.  A cash ratio of greater than 1.0 means the company has an excellent short-term debt-paying ability.

Short-term liquidity ratios

The key to a company's ability to meeting it's obligations may be in the length of time it takes to convert less liquid current assets into cash.  This is measured by the short-term liquidity ratios. 

The two turnover ratios can be very useful in valuation.  Trends in account receivable turnover ratios are frequently used in assessing the allowance for doubtful accounts, and trends in inventory turnover are used used in identifying potential inventory obsolescence problems.

Short-term liquidity ratios are very useful when comparisons can be made over time, or compared among other companies.  Of course, care needs to be taken when comparing companies to be assured that similar inventory valuations methods are being used.

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