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Sam Ghosh Founder and SEBI Regd. Investment Adviser at Wisejay Private Limited Bangalore, Karnataka
Financial Ratios Quick Guide, part 4 : Liquidity Ratios: Current Ratio, Quick Ratio, Cash Ratio
1 answer/comment
11:20:42 AM, 31st May, 2019
  • Sam GhoshFounder and SEBI Regd. Investment Adviser at Wisejay Private LimitedBangalore, Karnataka

    Before we discuss the ratios, let us understand that there are two types of debt for a company – Operational Debt and Financial Debt. When we discuss the health of a company based on credit structure, we often limit our concern to financial debt.

    So, what is the difference between operational and financial debts? Let us understand this with an example. Consider that you want to start a small manufacturing operation. You have 60% of the money required for the capital expenditure i.e. plant and machinery. So, you borrow the rest 40%. This 40% is the financial debt in the form of loan or bonds issued by the company. Now, you have built the facilities and started getting orders.

    The suppliers of raw materials give you a 15 days credit period on an average i.e. you can pay them 15 days after you they invoice you. You offer a 30 day credit period to your customers i.e. your customers get an average 30 days after the invoice date to pay you. Now, your suppliers are effectively loaning your money equal to the invoice amount for 15 days and you are also giving a loan to your customers an amount equal to the goods supplied for 30 days. This kind ‘loan’ is called operational debt which can also arise from the employees.

    The liquidity ratios fundamentally deal with your ability to pay off the operational debt.

    Note that after receiving the raw material there is a time lag to the invoicing to the customer. Let us assume that that time lag is 30 days for the above-mentioned example. This means that there is a time lag of 45 days (30 days credit to the customer + 30 days inventory in hand – 15 days credit from suppliers) between the amount paid to the suppliers for raw materials and getting money from the customer for the finished goods. The manufacturer needs to finance the inventory for these 45 days. This is an important factor, especially for growing operations. If the company has a large cash chest or other liquid assets such as marketable financial securities, that can be used to finance the inventories. It often happens that companies offer very competitive (i.e. longer) credit period to their customers and lower their margin to grow fast but end up in a cash crunch financing the inventory which also increases rapidly with the growth of the demand. A growing company may have to resort to financial debt or equity issuance to pay for the operational debt.

    The liquidity ratios deal with these concerns.


    IMPORTANT TERMS

    1. Accounts Receivable

    The amounts you are expected to get from your customers for the supplies you already made are called accounts receivable. As it represents future positive cash-flows, accounts receivable are considered assets.


    2. Accounts Payable

    The amount you are supposed to pay to the suppliers for the goods and services already supplied is called accounts payable. As it represents future negative cash-flow accounts payable are considered liabilities.


    3. Prepaid Expenses

    There are certain payments a company can make before the actual delivery of goods and services. For example, advance rent payment, advance payment to suppliers etc. These are called prepaid expenses and considered assets.


    4. Accrued Expenses

    Consider you are using a postpaid mobile connection for which bill is payable on the 30th of every month. So, at the end of the day on the 15th of the month, you have used 50% of the service but did not make any payments. But, this is still an expense in accounting terms. This is called accrued expenses. As this signifies a future negative cash-flow, accrued expenses are considered assets.

    This is a very simplified example, in real life, the calculations can be much more complicated.


    5. Unearned Revenue

    Unearned revenue is simply advance payment received before making the supply of goods and services. It is considered as a liability.


    6. Current Assets

    Current assets are assets which are either cash or equivalents or can be converted quickly to cash.


    Current Assets = Cash and equivalents + Inventory + Accounts receivable + Marketable Securities + Prepaid Expense + Other liquid Assets.


    7. Current Liabilities

    Current liabilities are liabilities which are payable in the current financial year.

    Current Liabilities = Short term loans + portion of long term loans payable in current financial year + Accounts payable + Accrued expenses + Unearned revenue


    8. Net Working Capital

    Net Working Capital = Current Assets – Current Liabilities

    This gives you are a quick idea about whether the current assets are enough to pay for the liabilities or you need to infuse cash to sustain operations. In the long run, net working capital gives us an idea of whether the business is a sustainable business. A business, which even after gaining maturity requires continuous cash infusion to sustain the net working capital, may be fundamentally unsustainable business and may require some fundamental changes.

    Also, an increasing working capital (which includes inventory) without the growth in revenue may indicate a slowdown in the demand and the production should be adjusted accordingly.



    Now, let us discuss the ratios.


    CURRENT RATIO

    Current Ratio = Current Assets / Current Liabilties.

    First of all, like all ratios, the current ratio also should be considered in comparison to peers. Also, the trend in the current ratio is much more informative than standalone numbers.

    A higher number is preferred but a number too high may point to too much inventory. Too much inventory compared to revenue indicates that the company is not efficient in managing operations. Just in time (JIT), processes can be helpful to manage this situation.


    QUICK RATIO

    Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities

    The problem with inventory is that it may not quickly convertible to cash. Consider a manufacturer company for whom the raw material is steel plates along with other things. The inventory for such company with comprise of semi-finished parts and finished parts along with the steel plates. Those semi-finished or finished parts cannot be readily converted to cash.


    This is why quick ratio ignores the inventory. Prepaid expenses also do not signify any positive cash-flow in future.

    The quick ratio is also called the Acid Test Ratio. A quick ratio of less than one is considered bad because the company will not be able to pay the current liabilities and may need a cash infusion.



    CASH RATIO

    Cash Ratio = (Cash + Marketable Securities) / Current Liabilties

    Not all current assets are made equally. We already understood that inventory cannot be readily converted to cash. Also, for a company going through some kind of crisis, accounts receivable may not be redeemable. Prepaid expenses do not convert to cash.

    Cash Ratio paints a very conservative picture about the liquidity of the company by only considering cash and marketable securities as current assets.

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