Lenders place much emphasis on these ratios in the analysis of the business but without an understanding of the components of the two parts of each ratio, the picture can be very misleading. This presentation takes a close look at both ratios so that they can be critically analysed and the correct understanding of the business’ liquidity position can be gained.

1. Liquidity: Analysing the
Current and Quick Ratios
from
businessbankingcoach.com
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2. During workshops
we’re often asked,
“what’s the benchmark”
or
“what’s the standard”
when we talk about
financial ratios.

3. And 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.

4. In spite of that, we still
hear reference to a
current ratio of 2 or a
quick ratio of 1 being
the “ideal”. In this
presentation 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’
liquidity.
The
current
and
quick
ratios

5. 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.

6. 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 now what the position is
now so get a balance sheet that’s as up to
date as possible.

7. 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).

8. 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;
Inventory
Accounts receivable
Bank and cash
1,600,000
200,000
200,000
Business 2;
Inventory
Accounts receivable
Bank and cash
800,000
500,000
700,000

9. 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.

10. Business 2 would appear
to be in a stronger position
as far as liquidity is
concerned – it has more
cash and less inventory –
but………

11. ……..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.

12. 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.
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.

13. 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.

14. 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.

15. 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.

16. Current liabilities are what we should be
most concerned as lenders since, if the
liabilities are accounts payable, 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.

17. 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.

18. 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.

19. 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….

20. 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.

21. 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.

22. 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 trade debtors 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?

23. If there are known slow
payers or potential bad
debts in the accounts
receivable figure, we
should remove them
from the total and recalculate the current
and quick ratios. We
want to know the worstcase scenario.
Pay me
now

24. What makes up the current liabilities? If
it’s all trade creditors 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…….

25. ……….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.