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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No Reason to Cheer Intel's Earnings

The predictably upbeat reception that was held for Intel (INTC) following the Company's Q2 earnings release, after hours yesterday, featured the well-told storyline that the economy has bottomed, and prosperity is just around the corner. To it's credit, Intel has managed to operate efficiently throughout the recession, reporting a quarterly revenue decline of only 15.2% compared to the same quarter in 2008. They've also taken the EU fine in stride, booking the $1.45B charge for Q2 and moving on. However, we take issue with any attempt to characterize these results as indicative of a pending turnaround in the Broader Economy.

First of all, to reiterate one of our common themes, Intel was able to "surprise" analysts through a combination of "less bad than expected" sales and, very importantly, across the board reductions in operating expense. Obviously, any comparison to Q2 '08 must take into account that oil was priced at ~$140/bbl; exerting upwards pressure on ANY petroleum based product. In addition to the cost-of-goods benefits, Intel clearly made the decision to trim it's marketing/G&A and research and development expenses. Compared to Q2 '08, these expenditures declined 12.5% and 11.2% respectively. Across both categories, these percentages represent cost cuts totaling $345M. This is important considering that one of the key figures cited by bulls as "surprisingly good" was the Company's Q2 gross margin percentage of 50.8% - a handful of percentage points above stated guidance of "mid-40-ish". This "surprise" is more than explained away by the substantial reductions to operating expense.

Secondly, the reaction to INTC's results shows the ability of economists to spin just about anything. For the past several months, economists have espoused the view that according to official inventory figures, the economy in general should benefit from a "re-stocking" effect in the second quarter as companies re-stock their barren inventories with new product. Surprisingly though, as soon as the oft-cited inventory dynamic begins to appear in corporate earnings reports, we are supposed to believe that this new demand is being driven solely by a stabilizing economy. We certainly aren't buying it.

*no position in INTC

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