Here is the balance sheet we're going to use as an example. You can see that there are two year's of data for this hypothetical firm. This is because ratio analysis is only a good tool if we can compare the ratios we calculate to either other year's of data or to industry averages.
Ahead we'll use the balance sheet data to calculate the current and quick ratios and net working capital while explaining each and what their change from year to year means. You can replicate the results for your own firm.
02Calculate the Company's Current Ratio
The first step in liquidity analysis is to calculate the company's current ratio. The current ratio show how many times over the firm can pay its current debt obligations based on its assets.
The formula is the following: 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 2008, the calculation would be the following:
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 met its current debt obligations. So, this firm is solvent.
In this case, however, 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 2007, you will see that the current ratio was 1.182 X. So, the firm improved its liquidity in 2008 which, in this case, is good since it is operating with relatively low liquidity.
03Calculate the Company's Quick Ratio or Acid Test
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 is 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 the following: 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 2008, the calculation would be the following:
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.
In this case, however, the firm will have to sell inventory to pay its short-term debt. If you calculate the quick ratio for 2007, you will see that it was 0.458 X. So, the firm improved its liquidity by 2008 which, in this case, is good since 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.
04Calculate the Company's Net Working Capital
A company's net working capital is the difference between its current assets and current liabilities:
Net Working Capital = Current Assets - Current Liabilities
For 2008, this company's net working capital would be:
$708 - 540 = $168
From this calculation, you already 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 2007, the company's net working capital was $99, so its net working capital position, and, thus, its liquidity position, has improved from 2007 to 2008.
05Summary of Our Liquidity Analysis
In this tutorial, we have looked at this firm's current ratio, quick ratio, and net working capital. These are the key components of a simple liquidity analysis for a business firm. More complex liquidity and cash analysis can be done for companies, but this simple liquidity analysis will get you started.
Let's take a look at this summary. This company has improved its liquidity position from 2007 to 2008 as indicated by all three metrics we've looked at. The current ratio and the net working capital positions have both improved. The quick ratio shows that the company still has to sell inventory in order to meet the current debt obligations, but the quick ratio is also improving.
In order to truly analyze this firm, we need to look at data for the industry in which this firm is in. It's good that we have two years of data for the firm as we can look at the trend in the ratios. However, we also need to compare the firm's ratios with the industry.
Analysis of Liquidity Position Using Financial Ratios
You will find everything you need for liquidity ratio analysis on the company's balance sheet. Liquidity has to do with a firm's assets and liabilities. In particular, liquidity looks at whether or not a firm can pay its current debt with its current assets.