The term “liquidity” refers to the speed with which an asset can be converted into cash without large discounts to its value. Some assets, such as accounts receivable, can easily be converted to cash with only small discounts. Other assets, such as buildings, can be converted into cash very quickly only if large price concessions are given. We therefore say that accounts receivable are more liquid than buildings.
All other things being equal, a firm with more liquid assets will be more able to meet its maturing obligations (i.e., its bills) than a firm with fewer liquid assets. As you might imagine, creditors are particularly concerned with a firm’s ability to pay its bills. To assess this ability, it is common to use the current ratio and/or the quick ratio.
The Current Ratio
Generally, a firm’s current assets are converted to cash (e.g., collecting on accounts receivables or selling its inventories) and this cash is used to retire its current liabilities. Therefore, it is logical to assess its ability to pay its bills by comparing the size of its current assets to the size of its current liabilities. The current ratio does exactly this. It is defined as:
Current Assets
Current Ratio = —————————–
Current Liabilities
Obviously, the higher the current ratio, the higher the likelihood that a firm will be able to pay its bills. So, from the creditor’s point of view, higher is better.
However, from a shareholder’s point of view this is not always the case. Current assets usually have a lower expected return than do fixed assets, so the shareholders would like to see that only the minimum amount of the company’s capital is invested in current assets. Of course, too little investment in current assets could be disastrous for both creditors and owners of the firm.
We can calculate the current ratio for 2004 for ROYAL BALI CEMERLANG by looking at the balance sheet. In this case, we have:
1,290.00
Current Ratio = ————– = 2.39 times
540.20
Meaning that ROYAL BALI CEMERLANG has 2.39 times as many current assets as current liabilities. We will determine later whether this is sufficient or not.
The Quick Ratio
Inventories are often the least liquid of the firm’s current assets. For this reason, many believe that a better measure of liquidity can be obtained by ignoring inventories. The result is known as the quick ratio (sometimes called the acid-test ratio), and is calculated as:
Assets – Inventories
Quick Ratio = —————————–
Current Liabilities
For ROYAL BALI CEMERLANG in 2004 the quick ratio is (ref: 2004 RBC Balance Sheet):
1,290.00 – 836.00
Quick Ratio = ———————— = 0.84 times
540.20
Notice that the quick ratio will always be less than the current ratio. This is by design. However, a quick ratio that is too low relative to the current ratio may indicate that inventories are higher than they should be.
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