Liquidity Ratios
Liquidity measures are used to evaluate a company’s ability to pay its bills on a regular week-to-week or month-to-month basis. There are two commonly used ratios that help to evaluate this, the current ratio and the quick ratio.
Current Ratio
The current ratio compares current assets with current liabilities.
The specific ratio is:
(Cash + Marketable Securities + Accounts Receivable + Inventory + Other Current Assets) / (Accounts Payable + Bank (Short-Term) Debt + Accrued Liabilities + Other Current Liabilities)
= Current Ratio
A ratio below 1.0 means that current assets are less than current liabilities. This is a clear indication that the company has liquidity problems. However, a ratio in excess of 1.0 does not necessarily mean that the company is adequately liquid. Higher is not necessarily better. The ratio can be high because the company has too much inventory or does a poor job of collecting its accounts receivable in a timely manner. Conversely, the ratio can be low because the company does not have or cannot afford the levels of inventory necessary to serve its customers in a competitive manner. Too much working capital is poor asset management; it is very expensive, can restrict cash flow, and inhibits the company’s ability to grow and prosper.
An appropriate ratio can be intelligently developed by evaluating each individual component. The questions to be answered include: How much cash and near cash does the company need in order to pay its bills and manage its very short-term liquidity? What credit terms should the company offer its customers as part of its strategy to satisfy those customers? What levels of finished goods inventory are needed to serve the marketplace? How much raw materials and components inventory is required to assure efficient production operations? These and other questions need to be answered in order to determine the current ratio that the company should try to achieve. Usually a ‘‘range of desirability’’ is created to adjust for seasonality and peak periods.
Quick Ratio (‘‘Acid Test’’ Ratio)
The quick ratio has the same purpose as the current ratio, but it is more immediate. It is the same as the current ratio except that it does not include inventory. Therefore, the ratio is:
(Cash + Marketable Securities + Accounts Receivable) / (Accounts Payable + Bank (Short-Term) Debt + Accrued Liabilities + Other Current Liabilities)
= Quick Ratio
In order to use the quick ratio as an analytical tool, it must be understood that there is a great difference in liquidity between accounts receivable and inventory. When a company is owed money by its customers (accounts receivable), it has already done its work; it has fulfilled its commitment by delivering fine products and services. Whatever money was necessary to accomplish this has already been spent. However—and it is a big however— in order to ‘‘liquefy’’ its inventory, the company must spend additional funds. Raw materials and work-in-process inventory have not yet become finished products. There is still work to be done, and funds still must be spent. While finished goods inventory has been completed, it has not yet been sold and delivered. Therefore, inventory is not a very liquid asset. It is classified as a current asset because it is expected to be turned into cash in less than a year, possibly within six months or even two months. Thus, it is a liquid asset when compared to fixed assets and long-term investments, but it is not liquid in the way that marketable securities and accounts receivable are.
Exceptions to Comfortable Levels
There are exceptions to our prior statement concerning comfortable levels for these liquidity ratios. If the current and quick ratios were in the ‘‘comfortable’’ range, but a substantial amount of bank debt were due the next day, the future of the company could be in serious jeopardy. If the current ratio were in the comfortable range, but the finished goods inventory that the company had on hand was not what the customers wanted, then the company’s ability to deliver product to its customers in a timely manner would be impaired, even though its current ratio was acceptable.
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