Work out liquidity and activity ratios and explain what they mean

CFA® Level I · Financial Statement Analysis · Financial Analysis Techniques · FSA.5.e

The idea

Liquidity ratios test whether near-term obligations can be met: the current ratio compares current assets with current liabilities, the quick ratio excludes inventory as the least reliably realisable item, and the cash ratio keeps only cash and marketable securities. Activity ratios measure how quickly stocks turn — days of inventory, days of receivables and days of payables — and combining them gives the cash conversion cycle, the number of days between paying for inputs and collecting from customers. A negative cycle means suppliers finance the business, which is a structural advantage rather than a ratio curiosity.

Formulas

Current ratio

current ratio = current assets ÷ current liabilities

current assets: cash, receivables and inventory
current liabilities: obligations due within a year

The broadest liquidity measure, and the least demanding: it counts inventory, which is the current asset least likely to become cash when it is needed.

Quick ratio

quick ratio = (cash + short-term investments + receivables) ÷ current liabilities

cash: cash and equivalents
short-term investments: marketable securities that can be sold at once
receivables: amounts owed by customers
current liabilities: obligations due within a year

The current ratio with inventory and prepaid expenses taken out. The gap between the two ratios is the company's inventory, which is the point of computing both.

Inventory turnover

inventory turnover = cost of goods sold ÷ average inventory

cost of goods sold: the cost of what was actually sold in the period
average inventory: opening and closing inventory averaged

Cost against cost: revenue in the numerator would mix a selling price with a cost and inflate the ratio. High turnover reads as efficient until it reads as stockouts.

Days of inventory on hand

DOH = 365 ÷ inventory turnover

inventory turnover: cost of goods sold ÷ average inventory

The same fact as turnover, in days, which is the form that goes into the cash conversion cycle. Every activity ratio has this pair: a number of times and a number of days.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does the quick ratio exclude that the current ratio includes?

CashWhy not: The most liquid asset of all, and the one a quick ratio most needs to keep.
Inventory — correct
Accounts receivableWhy not: Retained in the quick ratio — amounts already billed and due. It is inventory that still has to be sold before cash appears.

Inventory is the current asset least reliably convertible to cash at its carrying amount, particularly in the circumstances where liquidity matters.

A harder one

Days of inventory are 60, days of receivables 45 and days of payables 30. What is the cash conversion cycle?

45 daysWhy not: 60 − 45 + 30, with the receivables and payables signs swapped. Waiting for customers lengthens the cycle; supplier credit shortens it.
135 daysWhy not: 60 + 45 + 30 — everything added. Days of payables is the period suppliers finance, so it comes off.
75 days — correct

60 + 45 - 30 = 75 days between paying suppliers and collecting from customers, which is the period the company must finance from its own resources.

The hardest tier

A retailer reports a negative cash conversion cycle. What does this mean?

It collects from customers before paying suppliers — correct
Its inventory has become obsoleteWhy not: Obsolete stock would sit unsold and *lengthen* days of inventory, pushing the cycle up rather than below zero.
Its receivables are largely uncollectableWhy not: Uncollected receivables raise days of receivables, which also lengthens the cycle. A negative figure comes from collecting fast, not slowly.

Selling for cash while buying on credit produces this, and it funds growth without external capital. It also means rapid contraction consumes cash, since the payable balance unwinds as purchasing falls.

In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.

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