This article examines Liquidity Ratios and related datametrics including the Current Ratio and Working Capital, as well as the Quick Ratio and the Average Collection Ratio and Period which are intended to help you evaluate critical aspects of your QuickBooks Balance Sheet. These ‘numbers’ can give you much clearer insight into how the company is performing than just the raw figures, and these combinations give you clear indicators of areas needing attention, as well as areas where the business seems to be doing great. Liquidity ratios give business owners and other interested parties a sense of how well the company is positioned to convert assets to cash in order to meet its liabilities.
The current ratio is one measure of a company’s ability to meet its short term obligations. By definition the Current Ratio is:
Current Assets ÷ Current Liabilities = Current Ratio
Current assets are usually defined as those that can be converted to cash within a year, and current liabilities are obligations that come due within a year. So if a company has a Current Ratio of 3, it has sufficient assets to pay its liabilities 3 times over from liquid resources.
QuickBooks’ Summary Balance Sheet report is any east resource from which you can compute the current ratio, as well as the Working Capital and Quick Ratio, discussed in the following sections.
Analyzing the Current Ratio
Even though creditors tend to favor a business that has a high current ratio, the current ratio can be too high. If too much of a business’s resources are held in current assets such as cash, receivables, inventory and prepaid expenses), it can be a sign that company management is not investing assets in such a manner as to maximize return on investment. In order to properly assess current ratio, the closely related analytic, Working Capital should be evaluated along with computation of the Quick Ratio.
While we all like cash, because of its spendablity, cash doesn’t really do much to earn wealth over time. It is one of the measures of Current Assets used in the computation of the Current Ratio; but we need to look at cash, working capital and current ratio all as relatively equal datametrics of the health of a business. Working capital is defined as:
Current Assets – Current Liabilities = Working Capital
Working capital represents the value of the company’s assets that can be converted to cash in the near future, taking into account the payments that the company must make.
Yet even with these datametrics, there is always a need to conduct due diligence in looking at the make-up and operational aspects of both the assets and liabilities. This is because the current ratio is flawed in that it makes the assumption that the company’s current assets can be readily converted to cash to pay its liabilities; but this rarely is the case. While ‘cash’ is liquid, even some short term investments are not easily liquidated; or if they are, there may be a significant cost of liquidation. While you may have a large number of accounts receivable, just how many of them can you collect ‘today’ if hard pressed? And if you have ‘inventory’ in your business, a substantial ‘current asset’ if there ever was one, it isn’t exactly like you can sell that off ‘overnight’. No the reality is that not every ‘current asset’ is current at all.
So the current ratio must be evaluated with respect to the time it would actually take to convert assets; how long will it really take to collect receivables, or how long would it take to sell the company’s inventory. In other words, a business, and its’ lenders, need a more in-depth awareness of the make-up of the current assets in order to have real understanding of the company’s liquidity.
Evaluating Current Ratio and Working Capital in a Real World Context
So let’s look at a couple of ‘example companies’ to show us how reliance upon the current ratio can be very misleading without considering working capital.
Company 1 appears to be the winner when looking at their liquidity; it has a significant margin of current assets over current liabilities, a seemingly good current ratio, and working capital of $300,000. Company 2 has no margin of safety when it comes to their current asset/liability margin, thus a weak current ratio, nor do they have any available working capital.
But even though Company 1 looks ‘so good on paper’, let’s thoroughly examine some ‘specifics about their current assets that are not reflected in ‘just the numbers’. Digging a little deeper we quickly determine that both companies have an average payment period of 30-days for their current liabilities, but Company 1 will require 180 days to collect its’ outstanding receivables based upon past history. Company 1 also has ‘inventory turns’ of 365 days (just once per year) which means the time required to sell the inventory off is substantial. Company 2 on the other hand tends to be paid ‘cash’ by their customers at the time of sale, and their inventory turns roughly 12 times per year (once every 30 days).
While Company 1 seemed “picture perfect” the reality is that it isn’t really very liquid at all, it’s payables are coming due faster than its’ ability to generate cash; so the negative cash-flow is a serious situation despite the current ratio and working capital values. On the other hand, Company 2, which appeared to be in serious ‘financial’ shape, is far more liquid due to its ability to quickly convert assets to cash.
The Quick Ratio
The Quick Ratio is a more conservative measure of the company’s liquidity because it recognizes that not all ‘current assets’, especially inventory, are truly current. As such it excludes the value of inventory since it generally takes to convert inventory into cash, and if inventory must be sold quickly, then the company may likely be required accept a lower than book value of the inventory. As a result, Inventory is justifiably excluded from assets for purposes of this computation. By definition the Quick Ratio is:
(Current Assets – Inventory) ÷ Current Liabilities = Current Ratio
Generally the Quick Ratio should be 1 or higher, however this can vary by industry. In general, the higher the ratio the greater the company’s liquidity. As with the Current Ratio and Working Capital, it can beneficial to evaluate the Quick Ratio in the context of another datametric, the Average Collection Ratio and Period.
The Average Collection Ratio and Period
The Average Collection Rate is defined as the ratio of net credit sales to an average accounts receivable balance, and corresponding average collection period is analogous to inventory turns. Inventory turns tells you how long it takes to deplete your inventory stock, while the average collection period gives you a rough idea of how long it takes to collect money for sales made on credit.
If you have $1,000,000 in net sales for a year and your average monthly Accounts Receivable balance was $100,000 during that year then you are turning over inventory at the rate of ten times per year, so your average collection period is a little more than 36 days. Together, these two figures are reflective of your company’s operating cycle: the initial inventory investment, holding inventory until sold, collecting from the buyer, and then reinvesting that money in additional inventory.
Looking at Combined Results
So when we consider both the Average Collection Rate and Period, along with the components of the Quick Ratio, we can see if the length of time that the company has to pay its vendors is roughly the same as its average collection period, then payment and receipt schedules are right in line with one another and so a Quick Ratio of 1 is acceptable despite the fact that a 1 is typically consider a nominal Quick Ratio.
What’s ahead in Part 3 of this Series
Next time we will be looking at business measures related to their level or debt or equity when we examine Solvency ratios that help us determine how the business is funded.
Reference: Business Analysis for QuickBooks, Conrad Carlberg, Author, William “Bill” Murphy, Technical Editor; Wiley Publishing, 2009.