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Liquidity ratios are a type of financial ratio that is used in measuring a company’s liquidity or in other words ability to meet its short-term financial obligations. These ratios are used to evaluate a company’s ability to pay off its short-term liabilities with its short-term assets as they come due. Here are a few examples of liquidity ratios, along with a brief explanation for each:
Current Ratio
The current ratio is a type of liquidity ratio that measures a company’s ability to meet its short-term financial obligations. It is calculated by dividing a company’s current assets by its current liabilities which are both found in the balance sheet. Total current assets include cash and other assets that can be easily converted to cash, such as accounts receivable, marketable securities, and inventory. Total current liabilities include any debts or obligations that are due within the next 12 months, such as accounts payable, short-term loans, provisions, and accrued expenses.
It is used to determine a company’s liquidity, or its ability to pay off its short-term debts with its short-term or liquid assets. A current ratio of 1.0 or greater is generally considered good, as this indicates that a company has enough current assets to cover its current liabilities. Whereas, a current ratio of less than 1.0 indicates that a company might be having trouble becoming liquid and also might hinder its status because it might have to sell or liquidate its long-term assets in order to cover its short-term liabilities.
For example, in the above table, we can see that for September 24, 2022Apple Inc has total current assets(7) of $135.405 billion and total current liabilities of $153.982 billion, the current ratio would be:
Current Ratio = Total Current Assets / Total Current Liabilities
$135.405 billion / $153.982 billion which comes out to 0.88.
This indicates that AAPL was short of current assets to cover its current liabilities. This can be a red flag, indicating that the company may have difficulty meeting its short-term financial obligations. This situation is also known as being “liquidity constrained”.
It may indicate that Apple Inc. is not generating enough cash or other liquid assets to pay its bills and other short-term debts, and may have to sell long-term assets or raise additional capital to meet its financial obligations.
However, there can be some specific industries where a current ratio of less than 1 is common. For example, in the retail industry, it is common for a company to have more inventory than cash. Similarly, in the construction industry, it is common for a company to have more accounts payable than cash. In these cases, the current ratio alone may not provide an accurate picture of a company’s liquidity.
Quick Ratio (Acid-Test Ratio)
The quick ratio, also known as the acid-test ratio, is another type of liquidity ratio that measures a company’s ability to meet its short-term financial obligations using only its most liquid assets. Like the current ratio, it is used to determine a company’s liquidity, or its ability to pay off its short-term debts with its short-term assets, but it provides a more conservative measure of liquidity by excluding inventory from current assets.
The quick ratio is calculated by dividing the sum of a company’s cash, marketable securities and accounts receivable by its current liabilities. A ratio of 1.0 or greater is generally considered to be good, indicating that the company has enough liquid assets to cover its current liabilities. A ratio less than 1.0 may indicate that a company is having trouble meeting its short-term financial obligations and may be at risk of defaulting on its debts.
The quick ratio is considered more conservative than the current ratio because inventory is not considered a liquid asset, thus it excludes inventory from the numerator. It is a useful metric for assessing a company’s liquidity, particularly in the context of inventory and receivables.
Continuing with the above example of AAPL it comes to
Quick Ratio = (Total Current Assets – Inventory)/ Total Current Liabilities
($135.405 billion – $4.946 billion) / $153.982 which comes out to 0.85
When a company’s quick ratio is less than 1, it means that the company does not have enough liquid assets (cash, marketable securities, and accounts receivable) to cover its current liabilities. This is an indication that the company may have difficulty meeting its short-term financial obligations, and may have to sell long-term assets or raise additional capital to meet its debts. It’s considered a negative indication of a company’s liquidity and may indicate a higher risk of default.
Cash Ratio
The cash ratio is another liquidity ratio which measures a company’s ability to meet its short-term financial obligations using only its cash and cash equivalents. It is considered to be the most stringent measure of liquidity. This is calculated by dividing a company’s cash and cash equivalents by its total current liabilities. It gives an indication of how easily a company will be able to pay off its short-term obligations with just its cash and cash equivalents without the help of other current assets item.
A cash ratio of 1 or greater indicates that a company has enough cash to cover all of its current liabilities. However, a ratio below 1 means that the company does not have enough cash to cover its current liabilities. A cash ratio being a stringent measure suggests that a company must have at least 0.25 cash ratio in order to consider it a healthy ratio. If this is less than 0.25 it is considered as weak and may indicate that the company might face difficulty in meeting its short-term financial obligations.
It is important to note that the cash ratio is considered a restrictive measure of liquidity, as it only takes into account cash and cash equivalents, and ignores other current assets, such as marketable securities and accounts receivable. It is important to keep in mind that the cash ratio is just one measure of a company’s financial health, and should be analyzed in conjunction with other financial ratios and information such as industry standards and peers’ performance for a better interpretation of the ratio.
Continuing with the above example of AAPL it comes to
Cash Ratio = Cash & Cash Equivalents / Total Current Liabilities
$23.646 billion / $153.982 which comes out to just 0.154
A cash ratio of less than 0.25 indicates that AAPL has a very low level of liquidity. It means that the AAPL does not have enough cash and cash equivalents to cover even a quarter of its current liabilities. This is considered a weak cash ratio and may indicate that the company is facing difficulty in meeting its short-term financial obligations.
It could also be a sign that it is not generating enough cash from its operations, or is not managing its cash effectively. This can lead to potential liquidity issues and a higher risk of default. The company may need to raise additional capital or sell assets to meet its financial obligations.
Additionally, a cash ratio of less than 0.25 can indicate the company’s weak market position, low profitability and less liquidity which can scare investors away.
It’s important to keep in mind that a low cash ratio is not necessarily a definitive indication of financial distress, and it is important to analyze the company’s cash ratio in conjunction with other financial ratios and information such as industry standards and peers’ performance, as well as the company’s recent performance, future cash flow projections, and its ability to raise additional capital.
Net Working Capital
Net working capital (NWC) is a financial metric that measures a company’s liquidity and its ability to meet its short-term financial obligations. It is calculated as the difference between a company’s current assets and its current liabilities. Current assets include cash and other assets that can be easily converted to cash, such as accounts receivable and inventory, while current liabilities include any debts or obligations that are due within the next 12 months, such as accounts payable, short-term loans, and accrued expenses.
The formula for net working capital is: Net Working Capital = Total Current Assets – Total Current Liabilities
Let’s again take the above table as a reference and crunch some numbers.
Net Working Capital(2021) = $134.836 billion -$125.481 billion = $9.355 billion
Net Working Capital(2022) = $135.405 billion – $153.982 billion = -$18.577 billion
From the above analysis of the liquidity ratio, we can say that it is important to take a closer look at AAPL’s financials and operations to determine the cause of these low ratios and negative net working capital. The investor should also compare its ratios with industry standards and peers’ performance.
From this, we can recommend that the investor considering buying this stock should perform these steps: –
Monitor Apple’s future performance and cash flow projections.
Consider its ability to raise additional capital to meet its financial obligations.
Research the industry and investigate the reasons behind the low liquidity ratios.
Analyze its recent performance and financial history to determine if this is a short-term issue or a long-term trend.
It can be beneficial if so required to seek professional advice and consult a financial advisor.
Be aware of the additional risk involved with a company that has low liquidity ratios and negative net working capital.
In general, as an investor, it’s important to be aware of the potential risks when investing in a company with weak liquidity ratios and negative net working capital, but it’s also important to look at the company’s overall financial health and future prospects before making a decision
