Over the past three posts we’ve looked closely at the liquidity ratios and encouraged you to think carefully about what makes up the current assets and liabilities that go into the ratio calculation before making a judgement about whether the current and quick ratios are good or bad.
So to summarise, remember our example of the two businesses that had the same current ratios that each have current assets of 2m and current liabilities of 1m. Their current assets are structured as follows;
Trade debtors 200,000
Bank and cash 200,000
Trade debtors 500,000
Bank and cash 700,000
There is some key information that you need to have if you are to make an informed judgment call;
- What is the stock (inventory) in both businesses? If it is something that can be easily and quickly converted to cash, then Business 1 could actually be in a stronger position than it at first appears.
- What are the terms of trade, e.g. 30 days, 45 days? Who are the trade debtors (accounts receivable) and are they likely to pay the amounts owing to Business 1 and Business 2 when they fall due? If there are known slow payers or potential bad debts in the trade debtors figure, we should remove them from the trade debtors total and re-calculate the current and quick ratios. We want to know the worst-case scenario.
- What makes up the current liabilities? If it’s all trade creditors (accounts payable) and the terms of trade are the usual 30 days or less, there could be a problem if the current assets are not quickly convertible to cash (i.e. liquid). But, if the bulk of the current liabilities is short-term bank debt it might not be so much of a problem because banks tend to be a little more patient than trade creditors.
- If the current and quick ratios are low, does the business have a strong, sustainable cash flow that means it doesn’t have to hold cash on the balance sheet to pay its current liabilities. Think of businesses like major supermarkets with huge daily cash inflows – why would they sit with lots of current assets on the balance sheet when they can settle their current liabilities from that same daily cash flow? In their case, current and quick ratios are irrelevant.