You will find everything you need for liquidity ratio analysis
on the company's balance sheet. Liquidity has to do with a firm's assets and
liabilities. In particular, liquidity looks at whether or not a firm can pay
its current debt with its current assets.
Here is the balance sheet we're going to use as an
example. You can see that there are two year's of data for this hypothetical
firm. This is because ratio analysis is only a good tool if we can compare the
ratios we calculate to either other year's of data or to industry averages.
Ahead we'll use the balance sheet data to calculate the
current and quick ratios and net working capital while explaining each and what
their change from year to year means. You can replicate the results for your
own firm.
Calculate the
Company's Current Ratio
The first step in liquidity analysis is to calculate the
company's current ratio The current
ratio show how many times over the firm can pay its current debt obligations
based on its assets. The formula is the following:
Current Ratio =
Current Assets/Current Liabilities.
In the balance sheet, you can see the
highlighted numbers. Those are the ones you use for the calculation.
For
2008, the calculation would be the following:
Current Ratio = $708/$540 = 1.311 X
This means that the firm can meet its current (short-term)
debt obligations 1.311 times over. In order to stay solvent, the firm must have
a current ratio of at least 1.0 X, which means it can exactly met its current
debt obligations. So, this firm is solvent.
In this case, however, the firm is a little more liquid than
that. It can meet its current debt obligations and have a little left
over. If you calculate the current ratio for 2007, you will see that
the current ratio was 1.182 X. So, the firm improved its liquidity in
2008 which, in this case, is good since it is operating with relatively low
liquidity.
Calculate the
Company's Quick Ratio or Acid Test
The second step in liquidity analysis is to calculate the
company's quick ratio
or acid test. The quick ratio is a more
stringent test of liquidity than is the current ratio. It looks at how well the
company can meet its short-term debt obligations without having to sell any of
its inventory to do so.
Inventory is the least liquid of all the current assets
because you have to find a buyer for your inventory. Finding a buyer,
especially in a slow economy, is not always possible. Therefore, firms want to
be able to meet their short-term debt obligations without having to rely on
selling inventory.
The formula is the following:
Quick Ratio =
Current Assets-Inventory/Current Liabilities.
In the balance sheet, you can
see the highlighted numbers. Those are the ones you use for the calculation.
For 2008, the calculation would be the following:
Quick Ratio = $708-$422/$540 = 0.529
X
This means that the firm cannot meet its current
(short-term) debt obligations without selling inventory because the quick ratio
is 0.529 X which is less than 1.0 X. In order to stay solvent and pay its
short-term debt without selling inventory, the quick ratio must be at least 1.0
X, which it is not.
In this case, however, the firm will have to sell
inventory to pay its short-term debt. If you calculate the quick ratio
for 2007, you will see that it was 0.458 X. So, the firm improved its
liquidity by 2008 which, in this case, is good since it is operating with
relatively low liquidity. It needs to improve its quick ratio to above 1.0 X so
it won't have to sell inventory to meet its short-term debt obligations.
Calculate the
Company's Net Working Capital
A company's net working
capital is the difference between its current assets and
current liabilities:
Net Working Capital = Current Assets
- Current Liabilities
For 2008, this company's net working capital would be:
$708 - 540 = $168
From this calculation, you already know you have positive
net working capital with which to pay short-term debt obligations before you
even calculate the current ratio. You should be able to see the relationship
between the company's net working capital and its current ratio.
For 2007, the company's net working
capital was $99, so its net working capital position, and, thus, its liquidity
position, has improved from 2007 to 2008.
Summary of
Our Liquidity Analysis
In this tutorial, we have looked at this firm's current
ratio, quick ratio, and net working capital. These are the key components of a
simple liquidity analysis for a business firm. More complex liquidity and cash
analysis can be done for companies, but this simple liquidity analysis will get
you started.
Let's take a look at this summary. This company has
improved its liquidity position from 2007 to 2008 as indicated by all three
metrics we've looked at. The current ratio and the net working capital
positions have both improved. The quick ratio shows that the company still has
to sell inventory in order to meet the current debt obligations, but the quick
ratio is also improving.
In order to truly analyze this firm, we need to look at
data for the industry in which this firm is in. It's good that we have two
years of data for the firm as we can look at the trend in
the ratios. However, we also need to compare the firm's ratios with the
industry.
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