When running or acquiring a business, it is important to understand if the company is in danger of facing a potential liquidity crisis.
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What is a liquidity crisis? A liquidity crisis is an event when a company is unable to meet debt obligations, day-to-day operation costs, or expand the business. If a liquidity crisis occurs, the business is forced to do a limited number of things, none of them to get happy about: delay debt payment, sell illiquid assets at fire-sale prices, issue high yielding bonds, or dilute owner's equity by selling a portion of the business.
Lucky for you, buying a business that is about to have a liquidity crisis or running your business into one is avoidable. All it takes is a balance sheet, four liquidity ratio formulas, and some common sense.
Current ratio measures the ability of the business to pay off its current liabilities using current assets.
Current ratio = current assets / current liabilities.
The greater the ratio, the easier it is for the business to pay off current liabilities.
However, if the current ratio is too high, then the company might not be efficiently using its resources. So where is the happy balance?
After you find the current ratio of the business, compare it to its competitors and to companies that are fundamentally alike. However, sometimes a whole industry might get a little crazy about debt so make sure to also compare the current ratio with the industry's historical current ratios. Generally speaking, a current ratio of around 2:1 is acceptable.
Quick Ratio (or Acid Test)
The quick ratio is the same as the current ratio except that it does not consider inventory in its current assets.
Quick ratio = (current assets – inventory) / current liabilities.
The quick ratio, essentially, is the conservative version of the current ratio. This ratio is more suitable for businesses that hold relatively illiquid inventory or inventory that is worth considerably less than its stated book value (e.g. large machinery, outdated computer software).
Working capital is very similar to the quick ratio except that it expressed as an absolute number instead of a ratio.
Working capital = current assets – current liabilities
You can view working capital as the safety cushion against a liquidity crisis (or nasty dagger pointed at the business's chest if the number is negative).
Leverage measures how a company finances its assets. There are advantages and disadvantages of having high leverage.
Leverage = long-term debt / total equity
The advantage of higher leverage is that owners will reap higher returns when conditions are good and the business is profitable. Debt financing also has tax advantages over equity financing.
The disadvantage is that the more leverage a business uses, the less margin of error it has. When times are bad and it loses money, leverage multiples the losses as surely as it multiple the gains.
Another disadvantage of having high leverage is that creditors are less likely to finance a business with high leverage since creditors have more to lose on the downside and little to gain from up side. With higher leverage, a business faces a higher risk of being unable to meet debt obligations.
Learn More About Interpreting a Balance Sheet
Now that you understand liquidity ratios, it's time to learn a few more things about balance sheet interpretation. To learn more, read the other articles in the Balance Sheet Interpretation Series: