How to determine the liquidity of a company
The liquidity of a company is the ability to raise cash when the company needs it. Or the ability of a company to pay off it’s short term (<1 year) debts. There are various ratios involved when determining the liquidity. A company can sell assets to raise money. But some assets take longer to liquify than others. The most liquid asset is cash. Bonds are stocks that are also very liquid because they can be traded for cash very easily. There are some ratios that determine the liquidity of a company:
- Current ratio
- Quick ratio
36.1 Current ratio
The current ratio measures if the company is able to pay short-term debts (obligations). Short term in this context means all debt obligations that are about to expire within one year. The current ratio incorporates current liabilities and current assets. Current assets are all the assets a company has that are expected to be consumed or sold within standard business operations. You can find the current assets in the balance sheet.
36.1.1 How to use current ratio
- Higher is better
- Above 1 is considered healthy (always use industry average)
- Can be very different between industries
- Can be used to compare companies
36.1.2 Why do investors use current ratio in their analysis
Shows if the company can pay of short term debts if needed. A company that can't pay off it's short term debts might get in trouble if they have to pay off their short term debts for whatever reason.
36.1.3 Things to be aware of
- Only compare with other companies in the same industry
- Might be deluded
- Not all assets can always be quickly sold
- Can be manipulated by increasing or decreasing the assets and/or liabilities
The three steps every investor should look at:
- What is the current current ratio?
- What is the long term trend?
- How does it compare to the industry?
36.1.4 How to calculate current ratio
- Current ratio = current assets / current liabilities]
Current assets are:
- Inventory
- Accounts receivable
- Marketable securities
- Prepaid expenses
- Cash
- Cash equivalents
- Ther liquid assets
The current liabilities are short term obligations that are due within one year. These consist of:
- Short term debts (loans)
- Dividends
- Income taxes
- Accounts payable (customers that owe the company money)
- Interest payments (outstanding bonds or other loans)
The current liabilities are also found in the balance sheet. To calculate the current ratio:
- Current ratio = current assets / current liabilities
The result shows an investor if the company is able to pay all its short-term (<1 year) debts if they were due all at once. When the result of the above formula is below 1, then the company does not have enough capital after selling all its assets to pay all short-term debts. If the ratio drops far below 1 that might indicate the company is or will be in financial trouble anytime soon.
A current ratio of 1.5 indicates that the company has $1.5 in current assets to cover each $1 of liabilities. If this drops to $0.5 then the company can’t pay the debts if needed.
Although this gives an investor some clues, the current ratio may also be deluded. Because owning assets does not mean the company can easily sell them. Also, account receivables (customers that owe the company money) may be quite old which deludes the current ratio. As with all ratios, you should only compare them between the same industries and companies.
36.2 Quick ratio
36.2.2 How to use quick ratio
- Higher is better
- Above 1 is considered healthy (always use industry average)
- Can be very different between industries
- Can be used to compare companies
36.2.3 Why do investors use quick ratio in their analysis
Shows how fast the company can pay off its short term debts.
36.2.4. Things to be aware of
- Only compare with other companies in the same industry
- Incorporates only most liquid assets
36.2.5 How to calculate quick ratio
- Quick ratio = cash and equivalents plus marketable securities plus accounts receivable / current liabilities]
Real life example
A real life example of Tesla. You need the following data to determine operating ratio:
- Quick ratio = cash and equivalents plus marketable securities plus accounts receivable / current liabilities
- ($18,324,000 plus $519,000 plus $2,081,000) / $21,821,000 = 0.95
Tesla can pay off $0,95 for each $1 dollar in debt in the short term (using only fast liquid assets).
The quick ratio measures the same thing as the current ratio, only it uses the most liquid assets a company has. Meaning, the assets that can be sold for cash the easiest and fastest.
As the quick ratio only incorporates the most liquid assets, you should also check the current ratio which also includes less liquid assets. But they may be harder to sell.
Key Concepts:
- The liquidity of a company is the ability to raise cash when the company needs it. Or the ability of a company to pay off it’s short term (<1) debts.
- The current ratio measures if the company is able to pay short-term debts (obligations).
- The quick ratio measures the same thing as the current ratio, only it uses the most liquid assets a company has. Meaning, the assets that can be sold for cash the easiest and fastest.
Chapters: The Ultimate Investing Guide
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