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RAW - Liquidity***********************************************************************Ratio Analysis I-Club-List <strong>Workshop</strong>, Part 7Date: Mon. Feb. 2, 1998Leader: Jay BerrySubject: Liquidity Ratios - the Current RatioThis is the seventh part of the Ratio Analysis <strong>Workshop</strong>. It begins thediscussion of Liquidity Ratios.*03Examples of RatiosPrice/Value RatiosLiquidity RatiosCurrent RatioQuick RatioLeverage RatiosTurnover (or Activity) RatiosProfitability RatiosThe Current ratio is discussed in this session. The Quick Ratio will bediscussed in part 8.LIQUIDITY RATIOSINTRODUCTIONLiquidity ratios are used to measure the ability of a company to meetits short-term financial obligations. Sometimes the term solvency isused instead of liquidity. The intent of these ratios is to indicate ifa company will be able to generate enough cash to pay bills that arecoming due in the near future.Data used to calculate Liquidity ratios are contained in the BalanceSheet. A Balance Sheet contains details about the Total Assets andTotal Liabilities of a company. Analysts sometimes praise a company bysaying that it has a "strong" or "clean balance sheet". The terms"strong" and "clean" are used interchangeably to indicate that theassets are adequate to pay off the liabilities in a timely mannerduring both good and bad business conditions. High values for theliquidity ratios discussed below are an indication of a "strong"balance sheet with respect to meeting near term obligations. TheLeverage ratios, discussed after the Liquidity ratios, also enter intodetermining if a company has a "strong" balance sheet.____________________________________________________________________CURRENT RATIOThe Current Ratio is defined as:Current AssetsCurrent Ratio = -------------------Current LiabilitiesThe Current Ratio is probably the best known of the liquidity ratios.BACKGROUNDSomewhere, many years ago, I read that the current ratio was the firstratio used by bankers to determine if a company was worthy of receivinga loan. At that time it was considered that a company must have acurrent ratio of 2 or more in order to qualify for a loan. I do notknow how or why this threshold was established. However many books andarticles that discuss the current ratio still use 2 as a thresholdvalue. Sometimes there will be a qualifying statement that the value ofPage 1
RAW - Liquidity2 applies to manufacturing companies; but there is no guidance aboutwhat values should be used for other types of companies. Can anyoneelse provide some insight about appropriate values for the CurrentRatio? For now, my suggestion is to compare the current ratio of acompany with the average for its industry.THE BALANCE SHEETCurrent Assets and Current Liabilities are listed in a company'sBalance Sheet. Current Assets are the first sub-total at the top of thelist of assets. Current Liabilities are the first sub-total at the topof the list of liabilities. Knowledge of the components that are summedto calculate current assets and current liabilities will be helpful forinterpreting the significance of the current ratio.Current Assets are those assets that will normally convert to cashwithin one year or the company's normal business cycle, whichever islonger.Current Assets usually consist of four components:Cash and EquivalentsAccounts ReceivableInventoryOtherNote that the four components are listed in order of the relative timeit usually takes to convert them to cash. Cash and Equivalents arealready in the form of cash. Accounts Receivable represent inventorythat has been sold on credit and delivered to customers; it may take 30to 90 days until the customers pay with cash. Inventory still has to besold; then it will take another 30 to 90 days before payment will bereceived. Other is a catchall category for all other assets that willbe converted to cash sometime within a year.Next consider Current Liabilities. These are liabilities that willnormally be settled with cash within one year. The components ofcurrent liabilities are not as standardized as the components ofcurrent assets. However, typical components of current liabilitiescould include:Accounts payableNotes payable to banksCurrent maturity of long term debtCurrent potion of capital lease paymentsAccrued taxesOtherTHE VALUE LINE CURRENT POSITION BOXValue Line shows current assets and current liabilities in a boxlabeled CURRENT POSITION. This box is located a little over half waydown on the left side of a value Line sheet. The box shows three setsof current position data; data for each of the past two years plus thecurrent position at the end of the most recently reported quarter. Notethat value Line uses the same components for current assets that werelisted above. However, Value Line separates current liabilities intojust three components:Accounts payableDebt dueOtherAccounts payable listed by Value Line is the same as the Accountspayable listed above.Debt due listed by Value Line includes items such as Notes payable toPage 2
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