During workshops we’re often asked, “what’s the benchmark?” or
“what’s the standard?” when we talk about financial ratios. Our answer is always the same…. which is that there is no “benchmark” or “standard” – it all depends on the industry and the way in which the individual business structures its balance sheet.
In spite of that, we still hear reference to a current ratio of 2 or a quick ratio of 1 being the “ideal” or the “norm”. In this post we’ll take a close look at these two ratios so that you can analyse them more critically and get a better idea of the business’ true liquidity.
The current ratio
We use the current ratio to tell us whether a business was able to settle its current liabilities (mainly accounts payable and short-term bank borrowing from its current assets (usually inventory, accounts receivable and cash) at the balance sheet date.
Notice that we say “was able to meet its current liabilities” because the balance sheet you get this information from is always historical.
There’s no point using a balance sheet that’s 6 months old or more to establish the liquidity position of the business – it’s irrelevant if it’s based on old information. We need to know what the position is now – so get a balance sheet that’s as up to date as possible.
Even if you’re happy with the ratio, it’s important to take a look at what makes up the current assets total because current assets are not all equally liquid (i.e. easily convertible to cash).
For example, let’s say that there are two similar businesses that each have current assets of 2m and current liabilities of 1m. Their current assets are structured like this; business 1 has inventory of 1.5m and accounts receivable of .5m while business 2 has accounts receivable of 1m and cash of 1m.
So, both businesses have a current ratio of 2 but Business 1 is heavily reliant on inventory and, in most cases (but not in every case), it’s difficult to liquidate inventory quickly to settle short-term liabilities. This is especially true in manufacturing where inventory may have to go through a process of converting raw materials to finished goods.
Business 2 would appear to be in a stronger position as far as liquidity is concerned – it has more cash and less inventory – but there are still questions to be asked before we can have a good understanding of the ratio. We’ll deal with those questions a little later.
The point is this; you can’t simply look at the ratio (i.e. 2 in this case) and draw a conclusion – you have to look behind the numbers.
The quick ratio
Normally we would look at the current ratio in conjunction with the quick ratio which removes the inventory figure from the current assets total but even that can be misleading.
The quick ratio provides a better measure of overall liquidity only when a business’ inventory cannot be easily converted into cash.
Remember too that the total of current assets might include assets that are unlikely to be converted to cash (e.g. prepaid expenses, deferred tax). If so, either remove them or use the quick ratio to assess liquidity.
So, once again, you can’t simply look at the ratio and make a judgement. If inventory is easily convertible into cash, the quick ratio could give you the wrong picture (in the sense that liquidity looks worse than it actually is) and then, in that case, the current ratio is the preferred measure of overall liquidity.
We’ve talked about the role of current assets in the liquidity ratios but there’s another element to consider of course – the current liabilities.
Current liabilities are what we should be most concerned about as lenders since, if the liabilities are accounts payable to suppliers, they have the ability to severely restrict our customer’s ability to trade if they are not paid on time – they could even bring about our customer’s liquidation in extreme cases.
The question for us, then, is how the current liabilities are made up and what impact that has on our analysis of the customer’s liquidity position.
We previously talked about how to analyse the current assets to determine how liquid they really are – our next concern is how urgent the current liabilities are and how that urgency compares to the ability of our customer to generate cash flow from the current assets or through daily cash inflow.
So to summarise, remember our example of the two businesses that had the same current ratios? We said that you have to look at what makes up the current assets and the current liabilities on the balance sheet before making a judgement about whether the current and quick ratios are good or bad.
There is some key information that you need to have if you are to make an informed judgment call;
- What is the 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.
A point to keep in mind is that inventory can be made up of raw materials, work-in-progress (WIP) or finished goods depending on the type of business.
The ability of the business to turn each of these components into sales and then into cash may vary.
- What are the terms of trade, i.e. what credit is given to customers by the business, e.g. 30 days, 45 days?
- Who are the customers making up the accounts receivable figure 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 accounts receivable figure, we should remove them from the 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 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 suppliers.