Real Ratio
What is Real Ratio
The Real Ratio is a financial ration that measures a company's ability to pay off its current liabilities with its most liquid real assets (such as inventory and accounts receivable). It is calculated by dividing a company's real assets by its current liabilities. The higher the real ratio, the more liquid a company is and the better able it is to pay off its short-term liabilities.
The formula to calculate the Real Ratio is:
Real Ratio = (Inventory + Accounts Receivable) / Current Liabilities Purpose
The Real Ratio is primarily used to assess a company's financial health. It determines how capable a company is of meeting its short-term financial obligations using readily convertible assets. Importance
The Real Ratio is crucial because it provides insight into a company's financial stability. It can be particularly useful for creditors and investors who are interested in a company's ability to pay its liabilities in the short term. Benefits
The main benefit of the Real Ratio is that it provides a more stringent measure of a company's liquidity than other ratios, such as the current ratio or quick ratio. This is because it only considers the most liquid real assets. Pros and Cons
Pros:
- Offers a stringent measure of liquidity.
- Helps creditors and investors assess a company's short-term financial health.
- Useful for comparing the liquidity of different companies in the same industry.
Cons:
- May not be applicable to companies in different industries with different business models.
- Relies on the accuracy of inventory and accounts receivable valuations.
- Does not consider the company's long-term financial health.
Examples
Let's assume a company has $50,000 in inventory, $30,000 in accounts receivable, and $60,000 in current liabilities.
The Real Ratio would be:
Real Ratio = ($50,000 + $30,000) / $60,000 = 1.33
A Real Ratio of more than 1 indicates that the company has more than enough liquid assets to cover its current liabilities, thus implying that the company is in a good position to meet its short-term obligations. Conversely, a ratio of less than 1 would indicate potential liquidity issues.
See Also
- Current Ratio: The current ratio is a financial ratio that compares a company's current assets to its current liabilities. It is a commonly used indicator of liquidity and measures the organization's ability to pay off its short-term obligations using its current assets.
- Quick Ratio (acid-test ratio): The quick ratio is a more stringent measure of liquidity compared to the current ratio. It considers only the most liquid assets, such as cash, cash equivalents, and accounts receivable, and excludes inventory. This ratio provides a more conservative assessment of an organization's ability to meet short-term obligations.
- Cash Flow: Cash flow refers to the movement of money into and out of a business. Positive cash flow indicates that an organization is generating more cash inflows than outflows, which is essential for maintaining liquidity and meeting financial obligations.
- Working Capital: Working capital represents the difference between a company's current assets and its current liabilities. It measures the organization's short-term liquidity and ability to cover operational expenses. Positive working capital indicates a better capacity to meet short-term obligations.
- Liquidity Ratio: Liquidity ratios assess an organization's ability to convert its assets into cash to meet short-term obligations. Examples of liquidity ratios include the current ratio, quick ratio, and cash ratio. These ratios provide insights into an organization's liquidity position and its ability to weather financial challenges.