For anyone who has ever taken an accounting class this probably sounds familiar.
‘A good / well run business mush have a high Current ratio and High Quick Ratio.’
This is often one of the ratios your banker checks to get a feel for the liquidity of your company.
To those unfamiliar with the ratios Current ratio is a measure of liquidity of the company. It tells us if a company has the capacity to meet its short term or current obligations with short term or current assets. The way to calculate the current ratio is:
Current Ratio = Current Assets ÷ Current Liabilities
Generally a business with a current ratio under 1 is considered bad. A current ratio under 1 implies that for every dollar of current debt the business does not have a dollar in current assets to meet the obligation.
But Current Ratio has bit of a problem. It incorporates inventory as a part of Current Assets. A large inventory will yield a good current ratio. As will large amounts of Accounts Receivable and Cash amongst other things. As any business person will tell you keeping inventory is not cheap. By most estimates, in the manufacturing sector, cost of keeping inventory accounts for 30%-40% of the value of the product. And if that is not a scary thought, that same inventory cost reaches 70%-80% in case of service providers like accounting firms, bank analysts and consultants. So although the Current Ratio might be desirable by being higher than 1, it is possible that it is hurting the business much more significantly by causing a spike in inventory costs.
To adjust for the inflation of the Current Ratio by inventory, another ratio called the Quick Ratio was developed. Quick Ratio also measures the liquidity of the business but leaves out the inventory from the Current Assets. However it keeps the Current Liabilities at the same level as above. This is a more conservative ratio and hence also called the Acid Test Ratio. Quick Ratio is calculated as follows:
Current Ratio = (Current Assets – Inventory) ÷ Current Liabilities
Another challenge with inventory is that it is not easily convertible into cash. The Quick Ratio takes this into account and provides a much tighter liquidity measure. But this too is fraught with traps. By excluding inventory we get a better sense of liquidity but now our remaining Current Assets consist of mainly Cash and Receivables.High levels of both are not an optimum situation for a business.
High levels of cash generally signals that the business managers either unwilling or unable to find investment opportunities for the cash. Although this may look good on the balance sheet to most, for an investor/stakeholder in the business who depends on the astute judgment of the managers, this should raise concerns. Cash sitting on the balance sheet does not generate any profits; it does not create jobs, does not facilitate development of new technology and in general does not do much at all.
High Accounts Receivable is not a very charming sight on the balance sheet either. Accounts Receivable has capital tied up that is in the hands of someone else. Once again like Cash, this is not doing much for the growth of the business. It may be doing wonders for the people who owe this money but not to the receiver of the Accounts Receivable. High levels of Accounts Receivable especially those that are over 60 days and significantly those over 90 days are a sign of impending collectability of these receivables.
All the major components of the Current Asset portion of these equations have some potentially serious pitfalls. Yet we chase down both the Current Ratios and Quick Ratios without qualifying the results with caveats.
When looking at the Current Liabilities we must keep in mind some of the components like Accounts Payable, Notes Payable, any amount owed on a bank line of credit and unearned revenues are all cash inflows into the business. An increase in these causes an increase in the Current Liabilities and a decrease in both the Current and Quick Ratio.
A reasonable conclusion that one can draw from observing a these ratios over a period of time is that:
An Increase in Current Ratio => A shift of the management towards a more conservative capital management policy => Lower Risk => Lower Profit => Lower Return on Equity.
It is by no means wise to completely eliminate these ratios from the fundamental analysis of business. But, the results of these ratios should never alone be decision criteria for the health of a business. Perhaps it is time to look at these ratios more as guidelines and precursor to deeper questions and not an end on to itself.