Decoding liquidity ratios

A word that no investors want to hear in the stock market is bankruptcy.

When a company declares bankruptcy, there's a good chance of the company's stock being worthless.  

A company can go bankrupt for many reasons.

One possibility is that a company is insolvent, which means its total liabilities exceed its total assets. In this case, investors can use solvency ratios such as the debt ratio to measure a company's long-term financial health.  

A company may also go bankrupt if it faces a liquidity crisis. It means that the company doesn't have enough cash to pay short-term obligations like loans from banks, employee wages, or accounts payable to suppliers.

So, how can we know if a company can pay off short-term obligations or not?

There are three commonly used indicators: current ratio, quick ratio, and cash ratio.  

Let's start with the current ratio, also known as the working capital ratio. It is calculated by dividing a company's current assets by its current liabilities.

Current assets can be converted into cash within a year, such as cash, cash equivalents, accounts receivables, and inventory.

Current liabilities are obligations a company must pay off within a year, including short-term debts, accounts payable, and wages.

The current ratio tells investors whether a company has enough current assets to pay off its short-term obligations.

In general, a number of 1.5 is considered acceptable.

It indicates that a company has enough current assets to pay short-term obligations.

If a company has a current ratio under 1.00, it means the company doesn't have enough assets to cover its short-term obligations, raising a red flag for investors.

However, not all current assets can be liquidated instantly to pay off liabilities.

For example, inventory is not as liquid as other current assets, and it may take the company weeks or months to sell. Therefore, investors sometimes may prefer to use the quick ratio, which is more conservative.

The quick ratio equals dividing current assets, excluding inventory and prepaid expenses, by current liabilities.

It measures a company's capacity to pay its current liabilities without selling its inventory.

Generally speaking, a quick ratio of 1 is considered acceptable.

It means that a company has enough assets to be instantly liquidated to pay off its current liabilities. The lower the ratio, the higher the risk of default.

Compared to the two ratios mentioned earlier, the cash ratio is relatively more conservative.

It focuses only on the most liquid assets, cash and cash equivalents, including savings accounts, money market accounts funds, and T-Bills.

The formula to calculate the cash ratio is cash plus cash equivalents divided by current liabilities.

If a company's cash ratio is greater than 1, it means that the company has more than enough cash at hand to pay off short-term debt.

If a company's cash ratio is less than 1, the company may have difficulty paying off short-term obligations using cash.

In general, higher liquidity ratios are better than lower ones. It means that a company is less likely to have a liquidity crisis.

However, a ratio too high might not be a good sign. It may also suggest that the company doesn't use its assets efficiently.

In addition, the liquidity ratio differs by industry. The business model also matters.

For instance, retailers generally have lower quick ratios than most other industries as they have a large amount of inventory. So liquidity ratios are more suitable for comparing two companies in the same industry or comparing one company to the industry average.  

To sum up, investors can use current, quick, and cash ratios to measure a company's ability to pay short-term liabilities.

One should also consider the industry when using liquidity indicators.

This marks the end of the video. See you next time.