Liquidity Ratios for GM and Ford - Essay Example

Analysis of Liquidity ratios for GM and Ford The current ratio is a financial ratio used to determine the liquidity position of a company. The ratio is computed by dividing the current assets with the current liabilities to determine the proportion in which the current assets cover the current liabilities. The ratio assesses the company’s ability to pay off its short-term liabilities such as payables, accrued expenses and taxes, current portion of debt and the notes payable readily with its short-term debts such as inventory, marketable securities, receivables, cash, and cash equivalents. The higher the ratio the better it is for the company in theory but this does not hold truth in the real world situation. Despite the current ratio being used extensively in financial reporting, the ratio can be very misleading. In the real world situation, a high ratio does not necessary imply good liquidity position and a low current ratio does not necessary imply a bad liquidity position. This norm is contrary to the common belief of the current ratio as an adequate indicator of an entity’s liquidity. The ratio conceptualizes liquidation as the ability of a company’s current assets to offset its current liabilities. In the real sense, this does not occur as the investors’ measure a company, s liquidity as the going concern of the entity. According to the investors, a key indicator of a company’s liquidity is the time it takes for the conversion of working capital assets into cash to pay off its current debts. In a bid to prove this point, take two companies; one having a high current ratio and another company a relatively lower current ratio. The first company has longer accounts receivables days and a low inventory turnover. The second company has a short accounts receivables period and a higher inventory turnover. The first company has a higher current ratio than the second company does but this does not imply that the company has a better liquidity position. This is because working capital but the cash do not pay the current obligations and since it does not converts its current easily into cash; the company is illiquid (Bull 67). The quick ratio is also known as the acid-test ratio. The ratio is a more refined version of the current ratio. This is because it excludes the inventory in the summation of current assets to offset current debts. Omission of the inventory leaves more liquid current assets to cover the current obligations. The exclusion of the inventory is due to the difficulty in converting the asset into cash. A higher quick ratio implies a more liquid current position. By removing the inventory from the current assets portfolio, the quick ratio proves to be amore a conservative measure than the current ratio. The general concept and basis of the quick ratio is similar to that of the current ratio as it gives the user of the ratio an idea to determine the company’s ability to offset its short-term obligations using its short-term assets. It is very important to compare the company’s quick ratio with the current ratio. A bigger difference between the two companies implies that the company’s current assets portfolio is heavily relying on its inventory to cover the company’s current liabilities. Despite the quick ratio being a more stringent measure of a company’s liquidity than the current ratio, its accounts receivables suffer similar deficiencies as to that of current ratio. The quick ratio joins the current ratio in assuming the liquidity of the accounts receivable as a basis for measuring an entity’s liquidity. The going concern of a company focuses on the time it takes to convert the working capital into cash; therefore, it is important to assess the accounts receivable component of the quick ratio (Bull 70). GM’s current ratio is 1.27:1 in 2014 and 1.31:1 in 2013. The current ratio in both years shows that the company has the ability to offset its current obligations with all its current assets. This implies that the company’s observes a good a liquidity position in both the years. The current ratio has had a decline in the two-year period despite it maintaining the ratio more than one. This declining trend of the current ratio implies the company’s liquidity position is worsening as years go by. Failure to adjust the ratio back to its previous levels will put the company’s liquidity into question. GM’s quick ratio is 0.84:1in 2014 and 0.85:1 in 2013. This ratio gives a more reliable liquidity position of GM than the current ratio since it has the inventory, which is a slow moving asset. The difference between the company’s quick ratio and current ratio shows the extent in which the company depends on its inventory as current assets to offset its current obligation. The decrease in the quick ratio between the two periods is negligible hence showing the company has maintained the same liquidity position in the two years. Ford’s current ratio is 2.68:1in 2014 and 2.77:1 in 2013. The current ratio is high implying that the company finds it easy to offset the current obligations using its current assets. The decrease in the ratio over the two years is not of much concern since the ratio is high. The company’s quick ratio is 1.93:1 in 2014 and 2.03:1in 2013 showing that the company is still liquid despite the exclusion of inventory from its current assets portfolio. The high ratio in the ratio overrides the decreasing trend in the ratio in determination of the company’s liquidity position. GM’s current ratio in both the two years is lower than that of Ford .Since both the companies operate in the automotive industry, a comparison between the ratios of the two companies is essential in determination of their liquidity. According to the current ratios, Ford has a better liquidity position than GM. The quick ratio Ford is higher than that of GM in the entire two-year period. Since this ratio is used to determine a more reliable liquidity position of the company, it is evident that Ford has a better liquidity position than GM. The working capital of the two companies should also be considered, as the liquidity ratio does not exhaust a company’s determination of liquidity. Work Cited Bull, Richard. Financial Ratios. Oxford: CIMA, 2008. Print. Read More