Calculating A Firm’s Liquidity – Part 1

Current Ratio and Quick (Acid-Test) Ratio

A firm’s liquidity measures its short-term position and its ability to convert short-term assets to cash to pay its short-term obligations. The most effective method for determining a firm’s liquidity is the use of liquidity ratios.

Investors and analysts primarily use two ratios to measure liquidity: the current ratio and the quick (acid-test) ratio. The current ratio is the result of dividing current assets by current liabilities. It provides an indication of the amount of dollars a firm has in current assets for every dollar in current liabilities.

For example, if the ABC Company has $275,000 in current assets and $200,000 in current liabilities, its current ratio is 1.38 times. A current ratio of 1.38 times means the ABC Company has $1.38 in current assets for every $1 in current liabilities.

The quick ratio has the same objective as the current ratio, but it excludes inventory because inventory is not easily converted to cash. For example, if the ABC Company has $275,000 in current assets, but $45,000 is inventory, the quick ratio would be calculated by subtracting the inventory and then dividing the results by the $200,000 in current liabilities.

$275,000 current assets – $45,000 inventory = $230,000

$230,000 / $200,000 = 1.15 times

Excluding the inventory results in a quick ratio of 1.15 times. A quick ratio of 1.15 times means the ABC Company has $1.15 in highly-liquid assets for every $1 in current liabilities.

An ideal current ratio or quick ratio is 1.00 times, which means a firm has $1 in current assets for every $1 in current liabilities. However, the ideal ratio depends on industry norms and may vary across firms and industries.

Where can you find financial statement information for public companies?

You can find financial statements for most public companies on their websites on the “Investors” or the “Investor Relations” page. Because these companies are required to file annual and periodic financial statements with the Securities and Exchange Commission (SEC), you can also find their financial statements on the SEC’s website using the Edgar Search tool. If you are looking for a quick summary or overview that will prevent you from searching through a large amount of confusing or overwhelming information, you can find public companies’ financial statement information using their stock symbol (i.e. MSFT for the Microsoft Corporation) on websites that provide finance-related information such as Yahoo! Finance, MSN Money, or Google Finance.

Author: MixoBiz

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