Liquidity Measures: Net Working Capital, Current Ratio, and Quick Ratio

Liquidity measures help to ascertain a firm’s ability to pay operating expenses and other short-term, or current, liabilities. Because current liabilities, which are debts that must be paid or obligations that must be fulfilled, within 1 year, are paid out of current assets, which are received as cash or otherwise used within 1 year, liquidity measures are calculated using current assets and current liabilities.

Current assets include:

• cash and cash equivalents
• short-term investments
• account receivables
• inventory
• prepaid expenses

Current liabilities include:

• accounts payable
• short-term debt
• current interest payments for long-term debt
• salaries
• taxes

A low liquidity measure would indicate either that the company is having financial problems, or that the company is poorly managed; hence, a fairly high liquidity ratio is good. However, it shouldn’t be too high, because excess funds incur an opportunity cost and can probably be invested for a higher return. The 2 main measures of liquidity are net working capital and the current ratio.

Net Working Capital

Working capital is used to run the business and to pay its current liabilities. The sources of working capital include:

• internal sources
  • retained earnings
  • a shorter earnings cycle, which is the time from investing the cash to receiving cash for the finished product or service
  • cash flow from depreciation or deferred taxes
• external sources
  • loans
  • trade credit
  • debt and equity financing used for working capital

Net working capital is what remains after subtracting current liabilities from current assets; hence, it is money to run the business.

Net working capital is used for the cash conversion cycle (aka earnings cycle) of a business, which uses cash for raw materials, converts into the finished product, sells the product, then receives payment for it. This conversion cycle may vary depending on the type of business, but net working capital is essentially the cash needed to run the business.

Current Ratio

The current ratio (aka working capital ratio) is the ratio of current assets divided by current liabilities.

The current ratio is a measure of liquidity and shows how well a company can pay its current liabilities.

The current ratio gives an investor a better idea of how much safety a company has in paying its current liabilities regardless of the size of the company, whereas net working capital must be compared to the amount of liabilities.

As you can see, the net working capital of Big Company and Small Company are the same, but the small company has a much higher current ratio. Small Company has net working capital that is 11% of its liabilities, whereas Big Company has net working capital that is only 0.1% of its liabilities. In other words, Small Company has $1.11 for every $1 in current liabilities, whereas Big Company has only $1.001 for every $1 in current liabilities, a difference of 1/10^th of a penny! Hence, Small Company would be able to survive a financial downturn better than Big Company.

Whether a current ratio is good or bad depends on the type of business. For example, a service company that has little or no inventory would have a current ratio less than 1.5, while a company that carries a lot of inventory would typically have a current ratio greater than 2. And if the current ratio is less than 1, then that means that the company does not have enough current assets to pay current liabilities. Some real world examples (data accessed 12/1/2008):

• Intel, a manufacturer of computer chips with a lot of inventory: current ratio = 2.128
• Microsoft, a software company with a lot of cash: current ratio = 1.526
• GM, an auto manufacturer in financial trouble: current ratio = 0.729. This current ratio indicates that GM has only about 73 cents of current assets to pay every dollar of current liabilities. So if GM doesn't get a government bailout, which it is presently seeking, it may have to declare bankruptcy.

Quick Ratio

Current assets includes inventory and prepaid expenses, which are relatively illiquid compared to cash, short-term investments, and accounts receivable; hence, a better measure of liquidity for companies with large inventories or prepaid expenses is the quick ratio (aka acid-test ratio, quick asset ratio), which is the same as the current ratio, but without the value of inventory and prepaid expenses in the numerator.

In terms of current assets: