What is liquidity?
Liquidity is the measurement of a company’s ability to pay its current obligations. Vendors, creditors, and potential employees use liquidity to decide whether or not they should do business with a company. There are three ways to look at liquidity: working capital, the current ratio, and the quick ratio (also called the acid-test ratio). All of the liquidity measurements deal with current assets and current liabilities.
A current asset is an asset that the company will use up in 12 months or during the current operating cycle, whichever is longer. Some examples of current assets are cash, accounts receivable, inventory, prepaid expenses, and short-term investments.
A current liability is an obligation that will be paid within the next 12 months or during the current operating cycle, whichever is longer. Some examples of current liabilities are accounts payable, notes payable due in less than 12 months, sales tax payable, salaries payable, unearned revenue, and current portion of warranty liabilities.
Working Capital
Working capital is not a ratio. A ratio implies that there is division in the calculation. Working capital tells us the balance in current assets if all current liabilities were paid off. If we took all the current assets and used them to pay off all the current liabilities, whatever is left would be working capital.
Working Capital = Current Assets – Current Liabilities
If this calculation gives you a negative number, that means that the company does not have sufficient current assets to pay the current liabilities. That would be a very bad thing. Typically, that is a sign that the company won’t be in business much longer.
The Current Ratio
The current ratio uses the same numbers as working capital calculation but in a different way. Since we are using the term ratio, we know there must be division in this calculation.
Current Ratio = Current Assets / Current Liabilities
This ratio tells us the percentage of current assets to current liabilities. If your result was 75% or .75, your current assets cover 75% of your current liabilities. That’s not a good result. Anything less than 100% or 1.0 tells us that the company will have difficulty covering its current liabilities as they come due.
For this ratio, higher is better. Each additional digit means the company has could pay off its current liabilities again. For example, 2.3 or 230% means that the company could pay off its current liabilities 2.3 times with its current assets. If the number was 3.3, it could pay off its current liabilities 3.3 times.
The Quick Ratio (Acid-test ratio)
The current ratio has some flaws. It includes accounts that are technically current but may be more difficult to convert to cash. Inventory is often difficult to convert to cash immediately. Think of a retail company that must purchase its inventory months in advance for the holiday season. We know we can’t use that asset to pay off accounts payable in the next 30 days. Because of these flaws, we have the quick ratio, which is also sometimes called the acid-test ratio.
The quick ratio uses quick assets instead of current assets. Quick assets are cash and cash equivalents, accounts receivable, and marketable securities. The main current asset removed from this calculation is inventory because of its uncertain timing. Cash is already liquid and can be used to pay liabilities. Accounts receivable will generally turn to cash in 30-60 days. Marketable securities can be sold quickly with the cash used to pay liabilities. Inventory can be tricky. If the inventory is offseason or being held for an event, it cannot be sold now. Therefore, the cash from that inventory may not be available when needed.
The quick ratio is going to be smaller than the current ratio unless the company’s only current assets are cash and cash equivalents, accounts receivable, and marketable securities. That’s pretty rare so you usually do not see a company with the same number for the current and quick ratios.
Quick (acid-test) ratio = Quick assets (cash and cash equivalents + accounts receivable + marketable securities) / current liabilities
A quick ratio of 1 means that the company has sufficient quick assets to pay off all current liabilities. This is a good number. Just as with the current ratio, you want the number to be over 1 or as close to 1 as possible if below. The greater the number, the stronger the company is.
Which liquidity ratio is best for evaluating companies?
It’s hard to determine which of the ratios is best. Each has its place when evaluating a company. Sometimes we need to look deeper to determine which gives us the most accurate representation of the company’s strength. For example, if a company has a lot of current liabilities that must be paid in 30 to 60 days, then the quick ratio is the best way to evaluate if the company will be in a position to pay off those liabilities when they come due. However, if the liabilities are longer term or are estimates like warranty liabilities that might extend into the next year or may not materialize at all, the current ratio might be a fine measure of the companies ability to pay off debts.
The Working Capital formula is good for those who want to see absolute dollars but it is not good for comparing two companies of different sizes because the dollar amounts might make you think that there is a lot of extra assets but there is not relative to the amount of current liabilities the company has. For example, let’s say working capital is $57 million. That’s amazing for a company with $24 million in current liabilities but not very good for a company with $2.4 billion in current liabilities. Out of the three formulas, working capital is the least useful, especially when comparing multiple companies.
Can the current ratio and quick ratio ever be too high?
When we ask this question, what we are really asking is ‘Can a company have too many current assets?’ The answer is yes, it can. I know that may sound odd, but if a company has too many current assets, it may not be investing in things that will help the company grow. Idle current assets could be used to purchase equipment that could make production less expensive or purchase buildings to expand operations. That is a critisism we see of some large technology companies. They are sitting on a lot of cash, which could be used to purchase other companies or grow the business. Whoever thought there could be a scenario where a company had too many liquid assets?
