Written by Gregory Steffens for Gaebler Ventures
To effectively evaluate the credit worthiness of a company, one must calculate its liquidity ratios from the business' financial statements. This article introduces you to some common liquidity ratios and how they are calculated.
Should you be concerned about your company's current ratio or quick ratio?
The current and quick ratios measure a company's ability to meet its short and long-term obligations.
Let's take a look at these two ratios and understand why they are so popular with anybody who is evaluating company financials.
Calculated by taking a business' current assets and dividing them by its current liabilities, the current ratio measures a company's ability to pay off its short-term obligations or debts. Current assets are comprised of all a firm's assets that are considered relatively liquid and can be converted into cash within twelve months without losing value. This includes cash, accounts receivable, market securities, prepaid expenses, and other various liquid assets.
Current liabilities include all a firm's debts and obligations due within one year. This involves any short-term debt, accounts payable, accrued liabilities, and various short-term obligations. Both the current assets and liabilities are found in the financial statements, particularly the balance sheets, which firms include in their quarterly and annual reports.
A higher current ratio means that a firm is more capable to cover its short-term liabilities if they came due at that moment. For instance, if the ratio equals 1.5, the firm has one and a half dollars worth of short-term assets to pay off every dollar of its short-term liabilities.
However, a company with a larger ratio does not always mean that it is operating better than a company with a smaller ratio. A high current ratio could represent that the firm is not taking advantage of certain benefits in additional leverage. A ratio of 1 means the firm has an equal number of assets to cover its outstanding debts.
However, a current ratio of less than one represents the firm's lack of short-term, liquid assets to pay off its upcoming liabilities. Although this does not necessarily mean that the company will go bankrupt, a current ratio of less than one illustrates that the company may not be in good financial health.
To effectively evaluate the finance condition of the firm, one must compare its current ratio to the industry average and competitors in the industry.
Calculated by dividing a firm's quick assets by its current liabilities, the quick ratio is another measurement of a company's ability to cover its short-term obligations. Also referred to as an acid-test ratio, a quick ratio differs from a current ratio in that it does not include the firm's inventory in the calculation of assets.
Therefore, it is considered a more strenuous test and measures the firm's ability to pay off its short-term liabilities if it does not sell any of its inventories.
Like the current ratio, a quick ratio higher than one means that the company has sufficient liquid assets to meet its upcoming liabilities. A ratio below one can point to an unhealthy financial position for the company since it may not be able to meet its short-term debts. However, these numbers are relative to the industry.
For instance, the retail industry relies heavily on inventory turnover to meet its financial obligations. Since inventory is excluded in the calculation, the quick ratio can infer a financial hardship for a company when none exists. Like other ratios, the firm's quick ratio needs to be compared to the industry and its competitors.
Gregory Steffens is a talented writer with a strong interest in business strategy and strategic management. He is currently completing his MBA degree, with an emphasis in finance, at the University of Missouri.
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