Liquidity ratios help investors evaluate the ability of a company to turn assets into cash to meet its short-term obligations. If a company is to remain solvent, it must be able to meet its current liabilities, and therefore it must have an adequate amount of working capital.
By subtracting total current liabilities from total current assets, we obtain the company’s working capital, also referred to as net current assets.
WORKING CAPITAL RATIO OR CURRENT RATIO
The ability of a company to meet its obligations, expand its volume of business, and take advantage of financial opportunities as they arise is, to a large extent, determined by its working capital or current ratio position. Frequent causes of business failure are the lack of sufficient working capital and the inability to liquidate current assets readily.
The working capital for Trans-Canada Retail would be calculated as follows:
Current Assets (item 6) $12,238,000
Less: Current Liabilities (item 17) $4,410,000
Equals: Working Capital $7,828,000
This relationship is often expressed in terms of a ratio. In this example, the working capital ratio would be expressed as:
Current assets Current liabilities or Item 6 Item 17 $12 238,,, $ , , . : 000 4 410 000 2 78 1
Current assets are cash and other company possessions that can be readily turned into cash (and normally would be) within one year. Current liabilities are liabilities of the company that must be paid within the year. Trans-Canada Retail Stores Ltd. has $2.78 of cash and equivalents to pay for every $1 of its current liabilities.
The interpretation of the ratio depends on the type of business, the composition of current assets, inventory turnover rate, and credit terms. A current ratio of 2:1 is good but not exceptional, because it means the company has $2 cash and equivalents to pay for each $1 of its debt.
However, if 50% of Company A’s current assets were cash, whereas 90% of Company B’s current assets were in inventory, but each had a current ratio of 2:1, Company A would be more liquid than B because it could pay its current debts more easily and quickly.
Also, if a current ratio of 2:1 is good, is 20:1 ten times as good? No. If a company’s current ratio exceeds 5:1 and it consistently maintains such a high level, the company may have an unnecessary accumulation of funds which could indicate sales problems (too much inventory) or financial mismanagement.
Different businesses have different working capital requirements. In some businesses (such as distilleries), several years may elapse before the raw materials are processed and sold as finished products. Consequently, these businesses require a large amount of working capital to finance operations until they receive cash from the sale of finished products. In others (such as meat packers), the manufacturing process is much shorter. Cash from sales is received more quickly and is available to pay current debts. Such businesses can safely operate with less working capital.
CANADIAN SECURITIES COURSE • VOLUME 2 14•14
© CSI GLOBAL EDUCATION INC. (2010)
QUICK RATIO (THE ACID TEST)
The second of the two most common corporate liquidity ratios, the quick ratio, is a more stringent test than the current ratio. In this calculation, inventories, which are generally not considered liquid assets, are subtracted from current assets. The quick ratio shows how well current liabilities are covered by cash and by items with a ready cash value.
Current assets Inventories Current liabilities Item 6 Item 4 It e em 17 or $12,238,000 or $ , , $ , , $ , , $ , 9 035 000 4 410 000 3 203 000 4 4110 000, 0 73 1. :
Current assets include inventories that, at times, may be difficult to convert into cash. As well, because of changing market conditions, inventories may be carried on the balance sheet at inflated values. Therefore, the quick ratio offers a more conservative test of a company’s ability to meet its current obligations. Quick assets are current assets less inventories. In this example, the ratio is 0.73 to 1, which means there are 73 cents of current assets, exclusive of inventories, to meet each $1 of current liabilities.
There is no absolute standard for this ratio, but if it is 1:1 or better, it suggests a good liquid position. However, companies with a quick ratio of less than 1 to 1 may be equally good if they have a high rate of inventory turnover, because inventory that is turned over quickly is the equivalent of cash. In our example, however, a quick ratio of 0.73:1 is probably satisfactory, since the company we are looking at is a retail store chain, an industry characterized by large inventories and a high turnover rate.
OPERATING CASH FLOW RATIO
Cash flow from operations is an important measure as it indicates the company’s ability to generate cash from its day-to-day operations. A company needs cash inflows on a continual basis to pay its bills, finance growth and pay dividends. A positive cash flow from operating activities shows that the company was able to generate cash from its current business activities. Companies with negative cash flow from operating activities for periods of time will need to find other sources of funds such as borrowing, share issuance, or the sale of assets.
The operating cash flow ratio shows how well liabilities to be paid within one year are covered by the cash flow generated by the company’s operating activities:
Current flow from operations Current liabilities (Item 43 32 49 ) Item 17 or 41 42 50 1 298 000 4 410 000 0 29 1 $ , , $ , , . :
This ratio is used to assess whether or not a company generates enough cash from operations to cover its current obligations. An absolute standard does not exist for this ratio. However, if the ratio falls below 1.00, the company is not generating enough cash to meet its short-term requirements. When this occurs, the company may be forced to find other sources to fund its day-to-day operations or it may need to find ways to reduce the amount of cash being spent. For Trans-Canada Retail, an operating cash flow ratio of 0.29 means there are 29 cents of operational cash flow available for every $1 of liabilities. Such a low ratio may highlight a potential liquidity problem for the company. It may also emphasize other problems. Trans-Canada Retail carries a
fairly high level of inventory on its balance sheet. The longer it takes for the company to turn inventory into sales, the longer the time lag in receiving the cash needed to finance its operations.