LIQUIDITY RATIOS:
The first classification of ratios are known as Liquidity Ratios. As mentioned earlier, Liquidity Ratios measure a company's ability to provide sufficient cash to cover its short term obligations (debt). The most common liquidity ratios include; the current ratio and the quick ratio. Lets look at each type of liquidity ratio, beginning with the current ratio.
CURRENT RATIO:
The current ratio indicates the extent to which the claims of short-term creditors are covered by assets that are expected to be converted to cash in a period roughly corresponding to the maturity of the liabilities. Here's how the current ratio is calculated.
Current Ratio | = | Current Assets Current Liabilities |
As mentioned under the balance sheet section, a current liability represents money a company owes and is due in the near future- less than one year. A current asset, on the other hand, is cash or others short-term assets that can be converted into cash in the near future (IE less than a year). Inventory, for example, is a current asset that is purchased and sold by a company to obtain cash.
By dividing the current assets by the current liabilities, we can determine whether or not a company has the ability to pay off its short-term debt (current liabilities). Below shows the current assets and current liabilities for The Widget Manufacturing Company.
ASSETS: | LIABILITIES: | |||
Current Assets: | Current Liabilities: | |||
Cash | $ 2,550 | Accounts Payable | $ 9,500 | |
Marketable securities | $ 2,000 | Short-term Bank Loan | $11,375 | |
Account Receivable (Net) | $16,675 | Total Current Liabilities | $20,875 | |
Inventories | $26,470 | |||
Total Current Assets | $47,695 |
Using the values shown in the total current assets account and total current liabilities account we can calculate the company's current ratio as follows:
Current Ratio | = | Current Assets Current Liabilities |
= | $47,695 $20,875 |
= | 2.28 |
As you can see, The Widget Manufacturing Company has a current ratio of 2.28. That is, for every $1.00 the company owes in current liabilities, it has $2.28 worth of current assets. Therefore, if the Widget Manufacturing Company's short-term debt was due tomorrow, they would NOT have any difficulty in paying their creditors. Moreover, they would simply use the cash in their bank account , redeem their marketable securities, collect cash from customers who owe them (Accounts Receivable) and sell more products to customers.
Banks like to see a current ratio of at least 2 to 1 ; that is, for every $1.00 a company owes in short-term debt, it has $2.00 in current assets. Note: the higher the current ratio, the stronger the company is thought to be.
QUICK RATIO:
Some conservative minded investors don't like to use the current ratio as a indicator of whether or not a company has the ability to pay its short term obligations (debt). Instead, the quick ratio is used. The quick ratio is similar to the current ratio with one exception; that is, the quick ratio measures a company's ability to pay its short-term debt, without relying on the sale of its inventory. Therefore, in calculating a quick ratio, business owners must subtract the inventory from the current assets. The formula used to calculate the quick ratio is as follows;
Quick Ratio | = | Current Assets - Inventories Current Liabilities |
The three items required in calculating the quick ratio can be obtained from a company's balance sheet. Below shows the values of Widget Manufacturing Company's current assets and current liabilities on December 31, 200Y.
ASSETS: | LIABILITIES: | |||
Current Assets: | Current Liabilities: | |||
Cash | $ 2,550 | Accounts Payable | $ 9,500 | |
Marketable securities | $ 2,000 | Short-term Bank Loan | $11,375 | |
Account Receivable (Net) | $16,675 | Total Current Liabilities | $20,875 | |
Inventories | $26,470 | |||
Total Current Assets | $47,695 |
As you can see, as of December 31, 200Y, the company's total current assets are valued at $47,695, inventory valued at $26,470, and current liabilities are valued at $20,875. Using these amounts, the Widget Manufacturing Company would calculate its quick ratio as follows:
Quick Ratio | = | Current Assets - Inventories Current Liabilities |
= | $47,695 - $26,470 $20,875 |
= | 1.02 |
As shown above, the Widget Manufacturing Company has a quick ratio of 1.02. This means; for every $1.00 owed by the company in short-term debt, it has $1.02 of current assets (excluding inventory). In theory, if the Widget Manufacturing Company did not sell any more products, then it would have the ability to pay all of its short-term debt using its current assets; other than inventory. Note: the higher the quick ratio, the stronger the company is perceived to be. For further detail, please refer to our detailed article on the Quick Ratio.
Liquidity Ratio Summary:
In summary, the liquidity ratios consist of the Current Ratio and the Quick Ratio. The current ratio is calculated by dividing the current assets by the current liabilities. The quick ratio is calculated by dividing the current assets (excluding inventory) by the current liabilities. Below summarizes the current ratio and the quick ratio for the Widget Manufacturing Company as of December 31, 200Y.
Current Ratio | = | Current Assets Current Liabilities |
= | $47,695 $20,875 |
= | 2.28 | |||
Quick Ratio | = | Current Assets - Inventories Current Liabilities |
= | $47,695 - $26,470 $20,875 |
= | 1.02 |