Answer: Question 2.14 - Sentech Scientific Inc. 1. Liquidity is the ability of an asset to be converted into cash without significant price concessions. Liquidity is important to Sentech because current obligations will continue if there is a strike. Understanding the company’s ability to meet its obligations even if normal cash receipts are not forthcoming would give management an indication of whether or not – and for how long – it could weather a strike. Lack of liquidity can limit a company’s financial flexibility, making it unable to take advantage of discounts and other profitable opportunities. Liquidity problems can also lead to financial distress or bankruptcy.
2. Measures of liquidity include the following.
Current ratio: current assets/current liabilities Quick ratio (or acid-test ratio): (cash + marketable securities + accounts receivable)/current liabilities. The quick ratio excludes inventory and prepaid expenses from cash resources. Cash ratio: (cash + marketable securities)/current liabilities Only cash and securities that are easily convertible into cash are used. Net working capital: current asset – current liabilities Net working capital ratio: net working capital/total assets Sales to working capital: sales/average net working capital Accounts receivable turnover: net sales/average gross receivables This ratio can also be calculated in days. Inventory turnover: cost of goods sold/average inventory This ratio can also be calculated in days.
3. Based on the parameters set down by the controller, either the quick ratio or the cash ratio would be best. The reason that these ratios are best is because they focus on the most liquid assets, excluding prepaid expenses and inventories. During a strike inventories would not be a source of cash. The cash ratio excludes receivables as well, and would be the most conservative measure. The cash ratio would reflect the fact that the collection of receivables would be slowed during a strike.
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