Liquidity Measures: Net Working Capital, Current Ratio, Quick Ratio, and Cash Ratio
Liquidity measures measure 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
- prepaid expenses
Current liabilities include:
- accounts payable
- short-term debt
- current interest payments for long-term debt
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. Primary measures of liquidity are net working capital and the current ratio, quick ratio, and the cash ratio. By contrast, solvency ratios measure the ability of a company to continue as a going concern, by measuring the ratio of its long-term assets over long-term liabilities.
Net Working Capital
Working capital is used to run the business and to pay its current liabilities, of which a portion are operating expenses. 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
- 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||=||Current Assets||−||Current Liabilities|
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.
The current ratio (aka working capital ratio) is the ratio of current assets divided by current liabilities.
|Current Ratio||=|| |
The current ratio measures liquidity, showing how well a company can pay its current liabilities.
Example: Calculating the Current Ratio of Exxon Mobil for 2007
For its fiscal year ending December 31, 2007, Exxon Mobil Corp. (XOM) had total current assets of $85,963,000,000 and total current liabilities of $58,312,000,000. What is its current ratio?
Current Ratio = 85,963 / 58,312 = 1.47 (rounded)
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.
Example: Net Working Capital and Current Ratio of a Small and Large Company
Big Company has current assets of $1 billion and current liabilities of $999,000,000. Small Company has current assets of $10,000,000 and current liabilities of $9,000,000.
Net Working Capital of Big Company = $1,000,000,000 - $999,000,000 = $1,000,000
Net Working Capital of Small Company = $10,000,000 - $9,000,000 = $1,000,000
Current Ratio of Big Company = $1,000,000,000 / $999,000,000 = 1,000 / 999 = 1.001
Current Ratio of Small Company = 10 / 9 = 1.11
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 1/10th 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 exceeding 2. And if the current ratio is less than 1, then 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¢ of current assets to pay every dollar of current liabilities. So GM probably would have gone bankrupt without a government bailout.
The Current Ratio Is Easily Manipulated
Investors should be careful in using the current ratio to assess the solvency of a company, since it is easily manipulated. For instance, a company with $2 million worth of assets and $1 million worth of liabilities has a current ratio of 2. If the company buys $1 million worth of inventory, then current assets increases to $3 million while current liabilities increases to $2 million, yielding a current ratio of 1.5 to 1. On the other hand, if the company pays off $500,000 worth of debt, then current assets declines to $1.5 million while current liabilities declines to $500,000, yielding a current ratio of 3. Thus, management can easily change the current ratio by a factor of 2 or more.
Current assets includes inventory and prepaid expenses, which are relatively illiquid compared to cash, short-term investments and other marketable securities, 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 other words, only assets that can be quickly converted into cash (aka quick assets) are included in the numerator.
|( Cash |
+ Marketable Securities
+ Accounts Receivables )
In terms of current assets:
|( Current Assets |
- Prepaid Expenses )
Some businesses may have trouble converting their accounts receivables into cash quickly, so another measure of liquidity is the cash ratio, equal to the cash plus marketable securities over current liabilities:
|( Cash |
+ Marketable Securities )
The cash ratio is a better measure of the ability of a business to meet its current liabilities in business downturns. However, even the cash ratio may be insufficient in a general financial crisis, such as the recent 2007-2009 Great Recession, where marketable securities declined markedly in price, and some, such as mortgage-backed securities, could only be sold for pennies on the dollar.