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Liquidity Ratios

Can We Pay Our Bills?

Liquidity ratios tell you about your company’s ability to meet all its financial obligations—not just debt but payroll, payments to vendors, taxes, and so on. These ratios are particularly important to small businesses because small businesses are often in most danger of running out of cash. The ratios are also important whenever a larger company encounters financial trouble. Not to harp on the airlines too much, but again they are a case in point. You can bet that in the years right after 2001, professional investors and bondholders were carefully watching the liquidity ratios of some of the larger airlines.

Again, we’ll limit ourselves to two of the most common ratios.

CURRENT RATIO

The current ratio measures a company’s current assets against its current liabilities. Remember from the balance sheet chapters (part 3) that current in accountantese generally means a period of less than a year. So current assets are those that can be converted into cash in less than a year; the figure normally includes accounts receivable and inventory as well as cash. Current liabilities are those that will have to be paid off in less than a year, mostly accounts payable and short-term loans.

The formula and sample calculation for the current ratio (using the figures from the imaginary company in appendix A) are as follows:

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This is another ratio that can be both too low and too high. In most industries a current ratio is too low when it is getting close to 1. At that point, you are just barely able to cover the liabilities that will come due with the cash you’ll have coming in. Most bankers aren’t going to lend money to a company with a current ratio anywhere near 1. Less than 1, of course, is way too low, regardless of how much cash you have in the bank. With a current ratio of less than 1, you know you’re going to run short of cash sometime during the next year unless you can find a way of generating more cash or attracting more from investors.

A current ratio is too high when it suggests to outside shareholders that the company is sitting on its cash. Microsoft, for example, had amassed a cash hoard of nearly $60 billion (yes, billion) until 2004, when it announced a one-time dividend of $32 billion to its shareholders. You can imagine what its current ratio was before the dividend! (And it was probably pretty darn good after the dividend, too.) Whatever their size, fast-growing entrepreneurial companies need to pay special attention to this ratio, just because cash flow is always a challenge of high growth. A current ratio well above 1 can reassure a business owner that things will be OK. If the ratio heads down toward 1, it is time to pay attention.

QUICK RATIO

The quick ratio is also known as the acid test, which gives you an idea of its importance. Here are the formula and calculation:

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Notice that the quick ratio is the current ratio with inventory removed from the calculation. What’s the significance of subtracting inventory? Nearly everything else in the current assets category is cash or is easily transformed into cash. Most receivables, for example, will be paid in a month or two, so they’re almost as good as cash. The quick ratio shows how easy it would be for a company to pay off its short-term debt without waiting to sell off inventory or convert it into product. Any business that has a lot of cash tied up in inventory has to know that lenders and vendors will be looking at its quick ratio—and that they will be expecting it (in most cases) to be above 1.