Liquidity Ratios: Short Term Analysis
As we discussed earlier, financial ratios can help you understand what your financial statements are trying to tell you. Simply put, your financial statements may appear to be a mass of numbers and confusion, but by using ratios, your financial statements can tell you a story.
In our last blog post we discussed the four basic types of ratios, with the first being Liquidity Ratios. Liquidity ratios measure a business’s ability to pay its short term obligations. Now, I’m not a big fan on making strategic business decisions based on what a liquidity ratio is telling you. Why? Because liquidity ratios are for short term analysis, however you better believe that your bank is watching this – they have a vested interest in making sure you can pay your obligations – so you better be watching them too!
The most common liquidity ratio is the Current Ratio. Dust off your most recent Credit Agreement and find the section on your loan covenants, I bet you have a covenant regarding this ratio. You may even have different loan pricing if your Current Ratio exceeds certain levels – all the more reason to be watching this!
So let’s start with the basics. How do you calculate the Current Ratio? The Current Ratio is calculated as follows:
Current Ratio = Current Assets / Current Liabilities
The term “Current” means anything that will come to resolution within one year. For example, a current asset is expected to be converted into cash within a year and a current liability will be paid by cash within a year. In short, the Current Ratio measures your business’s ability to pay its bills within one year.
So, what is a good Current Ratio? At a minimum you want a ratio of 1.0, but that is still shaky ground. It would be better to be at 1.25 or even at 1.50. If you have a Current Ratio of 1.50 you’re in good shape and unlikely to get a call from your banker.
Other, less common liquidity ratios include the Acid-Test Ratio. This calculation is the same as the Current Ratio, only you subtract Inventory from your current assets. It’s a nasty name for a ratio, but it comes from gold mining lore when miners would test their gold in acid. If the gold did not dissolve it passed the acid-test. Just don’t go dipping your banker in acid if they ask you what your Acid-Test Ratio is!
About the Author
Geoff Chinnock is a consultant with Morrison, working primarily in our Business & Accounting Advisory practice. To get in touch with Geoff, please find contact information for Morrison here.