Tuesday, November 10, 2009

Liquidity Analysis Part 2: Current Ratio and Quick Ratio

In the first installment of my liquidity analysis discussion, I covered Net Working Capital; which is defined as Current Assets minus Current Liabilities. There are two additional ratios that should be a part of investor's liquidity analysis: the current ratio and the quick ratio. Both the current and the quick ratio are calculated entirely from the "current" section of the balance sheet. To refresh, current assets are cash, short term investments, receivables, inventory, or any other asset that the company expects will be converted to cash within a year or less. Current liabilities are accounts payable, expenses that accrue on a regular basis like wages, short term notes, and the portion of long term debt due within a year or less. The "due in one year or less" is a consistent theme which applies to current liabilites. To illustrate this distinction, I've included Intel Corporation's (INTC) consolidated balance sheet (2006-8) below:
Although not entirely scientific, I like to think of current assets and current liabilities as the corporation's revolving door; these portions of the balance sheet are turning over constantly between reporting periods. In contrast, non-current assets like buildings and machinery are relatively immutable, as are the portions of debt which mature many years down the road. In that sense, a corporation could own every parcel of land on the east coast, but without the liquidity contained in current assets, might conceivably be unable to pay it's bills or service it's debt. The previous example, although extreme, underscores the importance of applying both of the following ratios during your analysis of financial statements.

Current Ratio
The Current Ratio is simply current assets divided by current liabilities. The point is basically to measure how many times the firm's current assets can cover it's current liabilities. I'll use the figures from Intel's 2008 balance sheet to calculate it's current ratio.

Intel's Current Ratio = Current Assets / Current Liabilities
= $19,871M / $7818M
= 2.54

Generally, a current ratio above 1 is indicative of a strong current liquidity position. At 2.54, Intel appears to have more than sufficient liquidity necessary to cover it's payables and other short term debts coming due within the year.

Quick Ratio
I think of the quick ratio as a more precise glimpse into the firm's liquidity position. It basically measures whether the corporation could, if needed, quickly pay down all of it's current liabilities. The calculation here is Cash/Cash Equivalents divided by Current Liabilities. Below is a calculation of Intel's quick ratio for 2008:

Intel's Quick Ratio = Cash and Cash Equivalents / Current Liabilities
= $6512M / $7818M
= 0.83

To verbalize Intel's quick ratio, I'd say that Intel has 83% of the cash necessary to fund it's current liabilities. This is actually a relatively healthy quick ratio, and isn't expected to be greater than 1. Furthermore, if you look at the rest of Intel's current assets, you'll see $5331M worth of Short Term Investments. As Intel cashes out these investments over the subsequent twelve months, it will have substantially more cash than necessary to meet it's short term liquidity needs.

*Note: many analysts will include marketable securities and accounts receivable in the numerator of the quick ratio, the theory being that these items could be liquidated quickly. You may want to look at both calculations; however, I don't like assuming that a company can just go out and factor it's receivables on the market without taking a substantial hit.

As usual, it's important to monitor how these ratios change over time, as it will illustrate whether the firm is becoming more - or less - liquid with the passage of time. In the current environment, it should be obvious which way you'd like to see these measures trending.

*no positions
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