Can a company meet its financial obligations as they fall due? There are two commonly used liquidity ratios that could help you answer that question: current ratio and quick (acid) ratio. Both ratios measure the company’s ability to pay off its debt as it comes due.
Current ratio is calculated by dividing current assets by current liabilities. It basically indicates the extent to which company’s current liabilities are covered by those assets that can be easily converted into cash in the near future without a significant loss of value. Current ratio reveals the company’s ability to avoid insolvency in short run. Even though current ratio itself can give the investor an idea about company’s liquidity position, an industry average data is used for a precise and better assessment of company’s financial situation. For example, XYZ Company’s current ratio is $1,000 (current assets) / $400 (current liabilities) = 2.5 times. The industry average is 3.5 times. The firm has a lower current ratio than the average for the industry, which is a signal for poor standing relative to the other companies within the same industry sector. In case the company experiences financial difficulties, it would start serving its financial obligations more slowly, which could result in borrowing money and its current liabilities would increase. On the other hand, a high current ratio could mean that the company has tight up a lot of money in non-productive assets such as cash or excessive inventory. Shareholders prefer company’s funds to be actively reinvested in operating activities, external projects or to be distributed back to them.
Quick (Acid) ratio is current assets minus inventories divided by current liabilities. Typically, inventories are the least liquid of company’s current assets and therefore the most likely items that could cause a significant loss in case of bankruptcy. Quick ratio reflects firm’s ability to pay its short-term obligations without relying on the sale of inventories. If XYZ Company spent $500 in inventory, then its quick ratio would be ($1,000-$500) / $400 = 1.25 times. The industry average for the same year is 2.0 times. This means that firm’s ratio is low in comparison with other companies. XYZ Company’s quick ratio shows the same disturbing result like its current ratio. For XYZ Company, quick ratio is 2 times smaller than its current ratio. The only difference between both liquidity ratios is the inventories. Consequently, the high volume of inventories could be a red flag for asset management problems, which could significantly deteriorate company’s liquidity position. However, XYZ Company’s acid ratio is above 1, which means that if the accounts receivables can be collected on time, the company will be able to cover its current liabilities without having to liquidate its inventories. Quick ratio is a better measure of liquidity than the current ratio for companies whose inventory is not easily convertible into cash.
For obvious reasons, liquidity ratios are particularly interesting to investors, because they not only provide a snapshot of the company’s financial health, but they can also be used as a management performance measurement. For more on how to assess the financial health of a potential stock investment, check out Investing Daily’s report on Understanding the Stock Market and How to Buy Stocks.