Liquidity represents the ability of a company to convert its assets to cash, andliquidity ratios are often calculated from balance sheet data. Although there are many types of liquidity ratios, we focus here on a few of the more basic ones.
The most popular liquidity ratio is the current ratio. The current ratio is calculated by dividing all current assets by all current liabilities:
Current ratio = Current assets / Current liabilities
For the data in Figure 2.1 in the section “Elements of the Balance Sheet”,
Current ratio = $1,420,000 / $699,000 = 2.03
Current ratios that represent good liquidity and financial health vary widely across firms and industries. Currently, many companies have a current ratio between 1.3 and 1.5. Many companies have short-term lines of credit and other borrowing capacities that permit them to operate with a nearly balanced amount of current assets and current liabilities. In any event, the analyst would be worried to find current liabilities substantially in excess of current assets (in other words, when the current ratio is considerably less than 1). Declining trends in the current ratio would also cause concern, especially in conjunction with declining trends in other ratios.
Another major liquidity ratio is the quick ratio, which is often called the acid test. In this context, “quick”means close to cash. To calculate this ratio, cash and receivables are added and then divided by all current liabilities. In computing the quick ratio, the net realizable value of the accounts receivable should be used.
The purpose of the quick ratio is to indicate the resources that may be available quickly, in the short term, for repaying the current liabilities. For this reason, inventory and prepaid expenses are left out. In other words, the quick ratio is a type of “disaster” ratio that is used to indicate a worst case scenario that might apply if no other resources are available to pay the current liabilities that are due within the next year.
Quick ratio = (Cash + Receivables) / Current liabilities
For the data in Exhibit 3-1,
Quick ratio = ($110,000 + $466,000) / $699,000
Values for the quick ratio are often less than 1.0, and a rule of thumb used by some analysts is that the quick ratio should not be less than .30. Again, declining trends should cause the most concern. When comparing two companies, a lower quick ratio and a lower current ratio do not, in and of themselves, indicate that the company with the lower values is in worse financial condition. Lower liquidity may be offset by a variety of other financial indicators, such that the company with lower liquidity ratios could still rank higher on its overall financial stability and financial health.