Liquidity ratios measure a company's ability to pay off its short-term debt obligations. The four most commonly used Liquidity Ratios are explained below.

I will be using the financial statements of Cisco Systems, Inc. (CSCO) to illustrate how the ratios are computed. Please refer to my post on Important Financial Ratios For Analyzing Businesses for copy of Cisco's Income Statement, Balance Sheet and Cash Flow Statement.

#### 1) Current Ratio

The current ratio is used to test a company's liquidity, also referred to as its working capital position, by deriving the proportion of current assets available to cover current liabilities,
Formula : Current Ratio = Total Current Assets / Total Current Liabilities

Benchmark : A common rule of thumb is a ratio of 2:1.

Too high a current ratio might not be good as it may mean cash is not being utilized in an optimal manner.

Note : The use of current ratio as an indicator of liquidity is both flawed and misleading, conceptually it is based on the liquidation of all the current assets to meet all of the current liabilities. There is usually very little uncertainty about the amount of debts that are due, but there can be considerable doubt about the quality of accounts receivable or the cash value of inventory as well as the time it takes to convert inventory and other current assets into cash.

Calculation : The Current Ratio for Cisco as at 28 Jul 2012 is

__61,933 / 17,731__= 3.49.#### 2) Quick Ratio

Also known as acid-test ratio. It further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. It is more conservative as it excludes inventory and other current assets, which are more difficult to turn into cash. It is a test of whether a company can meets its obligations even if adverse conditions occur.

Formula : Quick Ratio = (Cash & Equivalents + Short-term Investments + Account Receivable) / Total Current Liabilities

Benchmark : In general, quick ratios between 0.5 and 1 are considered good as long as the collection of accounts receivable is not expected to slow.

Note : If the current ratio is much higher than the quick ratio, it means that a company's current assets are rely heavily on its inventory.

Calculation : The Quick Ratio for Cisco as at 28 Jul 2012 is (

__9,799+38,917+10,324) / 17,731__= 3.33.#### 3) Cash Ratio

The cash ratio measures the amount of cash, cash equivalents and short-term investments there are to cover current liabilities.

Formula : Cash Ratio = (Cash & Equivalents + Short-term Investments) / Total Current Liabilities

Benchmark : NA

Note : Cash ratio is the most stringent and conservative of the liquidity ratios. As it is not realistic for a company to maintain high level of cash assets to cover its current liabilities, cash ratio is seldom used in financial reporting or by analyst.

Calculation : The Cash Ratio for Cisco as at 28 Jul 2012 is (

__9,799+38,917____) / 17,731__= 2.75.#### 4) Cash Conversion Cycle

The cash conversion cycle (CCC) is the length of time that it takes for a company to convert resource inputs into cash flows It measures the number of days a company's cash is tied up in the production and sales process of its operations and the benefit it gets from payment terms from its creditors. The shorter the cycle, the less time capital is tied up in the business process, and thus the better for the company's bottom line. The CCC is also known as the "cash cycle", "asset conversion cycle" or "operating cycle".

Formula : Cash Conversion Cycle = DIO + DSO - DPO

DIO = Days Inventory Outstanding = Average Inventory / Cost of Sales per day

Average Inventory = (Previous year-end inventory + current year-end inventory)/2

Cost of Sales per day = Cost of Sales / 365

DIO measures how many days it take for the company's inventory to be converted to Sales, either as cash or accounts receivable.

DSO = Days Sales Outstanding = Average Accounts Receivable / Net Sales per day

Average Accounts Receivable = (Previous year-end AR + current year-end AR)/2

Net Sales per day = Net Sales / 365

DSO measures how many days it takes a company to collect on it's accounts receivable, i.e sales that are on credit.

DPO = Days Payable Outstanding = Average Accounts Payable / Cost of Sales per day

Average Account Payable = (Previous year-end AP + current year-end AP)/2

Cost of Sales per day = Cost of Sales / 365

DPO measures how long it takes a company to pay its obligations to supplier.

Benchmark : The shorter the cycle the better.

Calculation : The Cash Conversion Cycle for Cisco as at 28 Jul 2012 is ((

__1,663+1,486)/2)____/ (17,852/365) + ((10,324+10,219)/2) / (46,061/365) - ((4,063+4,159)/2) / (1,7,852/365)__= 32 days + 81 days - 84 days =29 days .
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