In the short term, there is an aspect that is more important than anything else for a company: remaining liquid, as otherwise it can not pay its short-term creditors and the interest on its debt, and might be declared bankrupt. Once in bankruptcy (Chapter 11 in the USA), a company either manages to restructure its debt, or it will be driven into liquidation and its assets sold to reimburse creditors. Shareholders get the rest once creditors have been served, but in practice usually get nothing from the proceeds – certainly an undesirable outcome. So remaining liquid is very important.
Liquidity is the degree to which a firm’s potential access to cash can cover its debt, seen in a short-term perspective, but in the large sense i.e. including current liabilities like tax payable and not only short-term interest-bearing debt and trade creditors. Liquidity ratios therefore compare current liabilities with current assets. For instance, the current ratio is defined as:
- current ratio = (current assets) / (current liabilities)
This ratio is sometimes called the “extended” current ratio as it includes all currents assets in the numerator.
The current ratio should be larger than one i.e. cash in hand and other current assets that can be expected to be turned in cash in the near term are sufficient to cover the short-term liabilities. When the current ratio is too low, this could signal a liquidity crisis. On the other hand, a high current ratio signals that there is room for improvement: either the company has too much inventory (inventory turnover can be improved), or collects its receivables too slowly from customers (collection period should be reduced), or has too much cash idle (which might be a transitory situation to finance an imminent investment). For most companies, the current ratio should be around two.
So a high and increasing current ratio is certainly not a good sign. The curse for a typical high-growth company is that current assets grow faster than current liabilities. When this happens, working capital is high and the current ratio increases. Cash is invested in inventories and receivables at high speed, which can lead to a cash liquidity crisis in case cash can not be raised from shareholders or banks. A very active cash and current asset management is critical in this growth phase.
As some current assets are more liquid than others, managers often focus on cash (including marketable securities) and invoices that customers have not paid yet, and exclude inventories from the current ratio, so as to derive a more conservative ratio called the “liquid ratio”, the “quick ratio” or the “acid-test”.
- liquid ratio = (cash + receivables) / (current liabilities)
Indeed inventories and work-in-progress must continue to be held by the company if it is to remain in business, so often can not be sold to reimburse short-term liabilities. The advantage of the liquid ratio compared to the current ratio is that it does not depend on the inventory valuation method: as it is not uncommon that inventories have to be written off for obsolescence, the value of inventories in the balance sheet might not be able to be turned into cash.
Some managers go one step further and define an even more conservative form of current ratio called the “cash ratio”, which as its name indicates, only includes cash (and marketable securities) in the numerator:
- cash ratio = cash / (current liabilities)
Shortly before failure, companies typically have very low cash ratio, low inventories, high receivables and comparatively low current ratios.
Note however that the cash ratio does not take into account the fact that the business might be able to borrow cash at short notice if it has a line of credit that it can draw on from a bank, so a low cash ratio is not necessarily bad news.
The conclusion here is that abnormal values for current, liquid or cash ratios should lead you to look deeper into the business to clarify why values are out of range.
If you need a concrete numerical example showing how liquidity ratios are calculated, then you will love our Financial ratio analysis Excel template for download.