3.5.3 Liquidity Ratios Notes

Liquidity Ratios: Current Ratio and Acid-Test Ratio

1. Liquidity ratios show whether a business has enough money to pay its bills.
2. If a company runs out of cash, it can’t pay suppliers, employees, or rent, even if it’s making profits on paper.
3. That’s why liquidity is just as important as profitability, a business that can’t pay its debts when they’re due is in trouble.

The Current Ratio

1. The current ratio checks if a business has enough current assets (things that can be quickly turned into cash, like cash itself, accounts receivable, and inventory),
2. To cover its current liabilities (short-term debts like supplier payments and loans due soon).
3. A ratio above 1 indicates that a company has more current assets than liabilities, suggesting good short-term financial health.

Current Ratio Formula

$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$

What to Watch Out For

1. In the past, a 2:1 ratio was seen as ideal, but today many businesses operate efficiently with 1.6:1.
2. If the current ratio is too high, say 3:1 or more, it might mean the company is holding too much cash or inventory instead of investing it wisely.

The Acid-Test (Quick) Ratio: A Stricter Measure

1. The acid-test ratio, also called the quick ratio, is a stricter test.
2. It removes stock from current assets because inventory can take time to sell, meaning it’s not as “liquid” as cash.
3. Understand that $$\text{Quick Assets = Current Assets - Inventory - Prepaid Expenses}$$

Acid Test Formula

$$\text{Acid-Test Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$$

Key Differences from the Current Ratio

1. A high current ratio but a low acid-test ratio means the company is relying too much on inventory to stay liquid.
2. A strong acid-test ratio (close to 1:1) means the company can pay its short-term debts without selling stock.

Industry Norms

1. Retailers often have lower acid-test ratios (as low as 0.4:1) because they rely on selling stock quickly.
2. Manufacturing businesses aim for around 1:1 because they need to cover short-term costs.

Interpreting Liquidity Ratios

1. A single ratio doesn’t tell the full story.
2. The best way to analyze liquidity is to compare a company’s ratios over time and against competitors.
3. Factors that affect liquidity ratios include:
   1. Industry Type – Retailers often have lower liquidity ratios than manufacturers.
   2. Business Model – Just-in-time businesses hold fewer assets, reducing their current ratio.
   3. Economic Conditions – During a recession, businesses may hoard cash, increasing their liquidity ratios.

Real World Examples

1. Microsoft Corp.: With a high current ratio of 2.5:1 and an acid-test ratio of 2.3:1, Microsoft demonstrates a strong liquidity position, indicating it can comfortably meet short-term obligations without relying heavily on inventory.
2. Walmart Inc.: The current ratio of 0.8:1 and acid-test ratio of 0.5:1 reflect retail industry norms, where companies often operate with lower liquidity ratios due to rapid inventory turnover and favorable credit terms with suppliers.
3. Pfizer Inc.: A current ratio of 1.9:1 and an acid-test ratio of 1.6:1 suggest that Pfizer maintains a healthy liquidity position, ensuring it can meet short-term liabilities while managing substantial inventories typical in the pharmaceutical industry.