Making Cows Turn to Cash

One of the financial management tool employed by companies to measure a company’s financial strength are financial ratio analyses. Financial statements data are used for such undertaking which will aide the users of financial statements especially the company’s shareholders perform critical decisions for the business.

Of the numerous financial ratio analyses, I will tackle on some of the most relevant financial ratios as tools in sound financial management judgment.

Liquidity Measurement Ratio:

Current Ratio:

The current ratio is used to test a company's liquidity (also referred to as working capital ratio) which is derived by dividing current assets over current liabilities.

The rationale behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). An ideal current ratio is 1, which is the quotient of this mathematical computation. Theoretically, higher the current ratio goes, the better.

Formula:

Current assets divided by Current liabilities

While current ratio could be easily understood, it could be misleading. When looking at the current ratio, it is important that a company's current assets can cover its current liabilities; however, investors should be aware that this is not the whole story on company liquidity as we take for example the case of accounts receivable, among others, where it’s effect is discussed further on the ratio explanation below.

One has to understand the types of current assets the company has and how quickly these can be converted into cash to meet current liabilities. This important perspective can be seen through the cash conversion time. By further examination into the current assets, one will gain a greater understanding of a company's true liquidity.

Quick Ratio:

Also known as quick assets ratio or the acid-test ratio, is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.

Formula:

Cash & cash equivalents+Short-term investments+Accounts receivable divided by Current liabilities

Another beneficial use is to compare the quick ratio with the current ratio. If the current ratio is significantly higher, it is a clear indication that the company's current assets are dependent on inventory.Some presentations of the quick ratio calculate quick assets (the formula's numerator) by simply subtracting the inventory figure from the total current assets figure. The rationale is that by excluding relatively less-liquid current assets such as inventory, the remaining current assets are all of the more-liquid variety.

Generally, this is close to the truth, but not always. We take for example a case where a company has restricted cash, prepaid expenses and deferred income taxes in its current assets. These current assets however do not pass the test of truly liquid assets. Thus, using the shortcut approach artificially overstates liquid assets and inflates its quick ratio.

Moreover, as we take the case of a accounts receivable: while theoretically feasible, if accounts receivable, as a component of the quick ratio, have, let's say, a conversion time of several months rather than several days, the "quickness" attribute of this ratio is questionable.

Investors need to be aware that the conventional wisdom regarding both the current and quick ratios as indicators of a company's liquidity can be misleading but nevertheless very useful in making management decisions.

On my future post, I shall further tackling on some basic debt ratios.