Analysis of Liquidity Position Using Financial Ratios

In this article, we will consider some commonly used liquidity ratios used in the financial analysis of a company. A balance sheet is provided as an example for calculating a company's financial position by measuring its liquidity, which is the ability to pay its current debt with its current assets. The information reflects two years of data for a hypothetical company.  

The balance sheet data will also be used to calculate the current ratio, quick ratio, and net working capital, as well as provide an explanation of each as well as the meaning of changes from year to year. The results can be replicated for your own firm or one that you are interested in investing in.

01
Calculate the Company's Current Ratio

Current Ratio Calculation and Analysis
Rosemary C. Peavler

The first step in liquidity analysis is to calculate the company's current ratio. The current ratio shows how many times over the firm can pay its current debt obligations based on its assets. "Current" usually means a short time period of less than twelve months. The formula is: 

Current Ratio = Current Assets/Current Liabilities

In the balance sheet, you can see the highlighted numbers. Those are the ones you use for the calculation. For 2018, the calculation would be:

Current Ratio = $708/$540 = 1.311 X

This means that the firm can meet its current short-term debt obligations 1.311 times over. In order to stay solvent, the firm must have a current ratio of at least 1.0 X, which means it can exactly meet its current debt obligations. So, this firm is solvent.

However, in this case, the firm is a little more liquid than that. It can meet its current debt obligations and have a little left over. If you calculate the current ratio for 2017, you will see that the current ratio was 1.182 X. So, the firm improved its liquidity in 2018 which, in this case, is good as it is operating with relatively low liquidity.

02
Calculate the Company's Quick Ratio or Acid Test

Quick Ratio Analysis
Rosemary C. Peavler

The second step in liquidity analysis is to calculate the company's quick ratio or acid test. The quick ratio is a more stringent test of liquidity than the current ratio. It looks at how well the company can meet its short-term debt obligations without having to sell any of its inventory to do so.

Inventory is the least liquid of all the current assets because you have to find a buyer for your inventory. Finding a buyer, especially in a slow economy, is not always possible. Therefore, firms want to be able to meet their short-term debt obligations without having to rely on selling inventory. The formula is: 

Quick Ratio = Current Assets-Inventory/Current Liabilities.

In the balance sheet, you can see the highlighted numbers. Those are the ones you use for the calculation. For 2018, the calculation would be: 

Quick Ratio = $708-$422/$540 = 0.529 X.

This means that the firm cannot meet its current short-term debt obligations without selling inventory because the quick ratio is 0.529 X, which is less than 1.0 X. In order to stay solvent and pay its short-term debt without selling inventory, the quick ratio must be at least 1.0 X, which it is not.

However, in this case, the firm will have to sell inventory to pay its short-term debt. If you calculate the quick ratio for 2017, you will see that it was 0.458 X. So, the firm improved its liquidity by 2018 which, in this case, is good, as it is operating with relatively low liquidity. It needs to improve its quick ratio to above 1.0 X so it won't have to sell inventory to meet its short-term debt obligations.

 

03
Calculate the Company's Net Working Capital

Net Working Capital Calculation and Analysis
Rosemary C. Peavler

A company's net working capital is the difference between its current assets and current liabilities:

Net Working Capital = Current Assets - Current Liabilities

For 2018, this company's net working capital would be:

$708 - 540 = $168

From this calculation, you know you have positive net working capital with which to pay short-term debt obligations before you even calculate the current ratio. You should be able to see the relationship between the company's net working capital and its current ratio.

For 2017, the company's net working capital was $99, so its net working capital position, and, thus, its liquidity position, has improved from 2017 to 2018.

04
Summary of Liquidity Analysis

Summary of the Liquidity Analysis
Rosemary C. Peavler

In this example, you performed a simple analysis of a firm's current ratio, quick ratio, and net working capital. These are the key components of a basic liquidity analysis for a business. More complex liquidity and cash analysis can be done for companies, but this simple liquidity analysis will get you started.

Looking at this summary, the company improved its liquidity position from 2017 to 2018, as indicated by all three metrics. The current ratio and the net working capital positions both improved. The quick ratio shows that the company has to sell inventory to meet its current debt obligations, but the quick ratio is also improving.

For a true analysis of this firm, it also is important to examine data for this firm's industry. Although it's helpful to have two years of data for the firm, which provides information on the trend in the ratios, it is also important to compare the firm's ratios with the industry.