Purchasing and Financing 2024

When evaluating the Growth of a Business the Net Profit Margin must be calculated and
when evaluating the Returns on Investment in a Company, both the Return on Equity and
the Return on Assets must be calculated.
Evaluating the Financial Condition and Liquidity of a company
a. Short Term Financial Condition and Liquidity
Firstly, we must consider whether a business can pay its debts to remain in operation.
Under the Accrual Accounting Method, the revenue is recognized when earned, whether
cash is received as payment. Since sales may be on credit, even profitable companies may
be at risk due to too much debt or a shortage of liquid assets.
To evaluate the short-term financial condition and liquidity of a company we must analyse
the Balance Sheet and calculate the Current Ratio, the Quick Ratio, and Working Capital.
1. Current Ratio = Current Assets/Current Liabilities
This accounting ratio measures the ability of a company to pay its debts over the next 12
months. As a rule, a company should have more than twice the assets to pay debt
obligations, or a ratio equal or greater than two. Anything below one is an indication that
the company may not be able to meet its short-term financial obligations.
Because short-term assets can be quickly turned into cash quickly, it is also a measure of
market liquidity. Ratios that are too high may indicate that assets are not being utilized
efficiently. This is not as concerning as a low ratio but may affect long-term growth.
As with all Accounting Formulas and ratios, each should be compared to the relative
industry and competition. Often each industry has its own standard for acceptable
amounts. For example, luxury items may need a higher ratio during economic downturns
since consumers are less likely to purchase luxury items when budgets are tight.
2. Quick Ratio (Acid Test) = (Current Assets - Inventory)/Current Liabilities
Though inventory is a current asset, it is more difficult to liquidate, and values more
difficult to determine. Products no longer in demand are often liquidated at steep
discounts, which often occur in the retail industry during seasonal changes.
The Quick Ratio, or acid test, is therefore a better measure of liquidity as it only includes
those assets that are more easily convertible to cash (Quick Assets), such as cash
equivalents, receivables, and marketable securities.
A ratio of 1.5 or more is considered adequate to cover short term debts, and a ratio of less
than one is a clear warning signal that a company may not be able to pay its short-term
debts. Industry standards should always be considered when comparing the ratios.
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