As the name suggests, short-term solvency ratios as a group are intended to provide information about a firm’s liquidity, and these ratios are sometimes called liquidity measures. The primary concern is the firm’s ability to pay its bills over the short run without undue stress. Consequently, these ratios focus on current assets and current liabilities.
For obvious reasons, liquidity ratios are particularly interesting to short-term creditors. Because financial managers work constantly with banks and other short-term lenders, an understanding of these ratios is essential.
One advantage of looking at current assets and liabilities is that their book values and market values are likely to be similar. Often (though not always), these assets and liabilities just don’t live long enough for the two to get seriously out of step. On the other hand, like any type of near-cash, current assets and liabilities can and do change fairly rapidly, so today’s amounts may not be a reliable guide to the future.
Current Ratio One of the best known and most widely used ratios is the current ratio. As you might guess, the current ratio is defined as follows:
Here is Prufrock’s 2015 current ratio:
Because current assets and liabilities are, in principle, converted to cash over the following 12 months, the current ratio is a measure of short-term liquidity. The unit of measurement is either dollars or times. So, we could say Prufrock has $1.31 in current assets for every $1 in current liabilities, or we could say Prufrock has its current liabilities covered 1.31 times over.
To a creditor—particularly a short-term creditor such as a supplier—the higher the current ratio, the better. To the firm, a high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short-term assets. Absent some extraordinary circumstances, we would expect to see a current ratio of at least 1 because a current ratio of less than 1 would mean that net working capital (current assets less current liabilities) is negative. This would be unusual in a healthy firm, at least for most types of businesses.
Go to www.reuters.com to examine comparative ratios for a huge number of companies.
Page 59The current ratio, like any ratio, is affected by various types of transactions. For example, suppose the firm borrows over the long term to raise money. The short-run effect would be an increase in cash from the issue proceeds and an increase in long-term debt. Current liabilities would not be affected, so the current ratio would rise.
Finally, note that an apparently low current ratio may not be a bad sign for a company with a large reserve of untapped borrowing power.
EXAMPLE 3.1 Current Events
Suppose a firm pays off some of its suppliers and short-term creditors. What happens to the current ratio? Suppose a firm buys some inventory. What happens in this case? What happens if a firm sells some merchandise?
The first case is a trick question. What happens is that the current ratio moves away from 1. If it is greater than 1 (the usual case), it will get bigger. But if it is less than 1, it will get smaller. To see this, suppose the firm has $4 in current assets and $2 in current liabilities for a current ratio of 2. If we use $1 in cash to reduce current liabilities, then the new current ratio is ($4 – 1)/($2 – 1) = 3. If we reverse the original situation to $2 in current assets and $4 in current liabilities, then the change will cause the current ratio to fall to 1/3 from 1/2.
The second case is not quite as tricky. Nothing happens to the current ratio because cash goes down while inventory goes up—total current assets are unaffected.
In the third case, the current ratio will usually rise because inventory is normally shown at cost and the sale will normally be at something greater than cost (the difference is the markup). The increase in either cash or receivables is therefore greater than the decrease in inventory. This increases current assets, and the current ratio rises.
The Quick (or Acid-Test) Ratio Inventory is often the least liquid current asset. It’s also the one for which the book values are least reliable as measures of market value because the quality of the inventory isn’t considered. Some of the inventory may later turn out to be damaged, obsolete, or lost.
More to the point, relatively large inventories are often a sign of short-term trouble. The firm may have overestimated sales and overbought or overproduced as a result. In this case, the firm may have a substantial portion of its liquidity tied up in slow-moving inventory.
To further evaluate liquidity, the quick, or acid-test, ratio is computed just like the current ratio, except inventory is omitted:
Notice that using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio. Again, the idea is that inventory is relatively illiquid compared to cash.
For Prufrock, this ratio for 2015 was:
The quick ratio here tells a somewhat different story than the current ratio because inventory accounts for more than half of Prufrock’s current assets. To exaggerate the point, if this inventory consisted of, say, unsold nuclear power plants, then this would be a cause for concern.
Page 60To give an example of current versus quick ratios, based on recent financial statements, Walmart and Manpower Inc. had current ratios of .83 and .14, respectively. However, Manpower carries no inventory to speak of, whereas Walmart’s current assets are virtually all inventory. As a result, Walmart’s quick ratio was only .22, whereas Manpower’s was .14, the same as its current ratio.
Other Liquidity Ratios We briefly mention three other measures of liquidity. A very short-term creditor might be interested in the cash ratio:
You can verify that for 2015 this works out to be .18 times for Prufrock.
Because net working capital, or NWC, is frequently viewed as the amount of short-term liquidity a firm has, we can consider the ratio of NWC to total assets:
A relatively low value might indicate relatively low levels of liquidity. Here, this ratio works out to be ($708 − 540)/$3,588 = 4.7%.
Finally, imagine that Prufrock was facing a strike and cash inflows began to dry up. How long could the business keep running? One answer is given by the interval measure:
Total costs for the year, excluding depreciation and interest, were $1,344. The average daily cost was $1,344/365 = $3.68 per day.1 The interval measure is thus $708/$3.68 = 192 days. Based on this, Prufrock could hang on for six months or so.2
The interval measure (or something similar) is also useful for newly founded or start-up companies that often have little in the way of revenues. For such companies, the interval measure indicates how long the company can operate until it needs another round of financing. The average daily operating cost for start-up companies is often called the burn rate, meaning the rate at which cash is burned in the race to become profitable.
LONG-TERM SOLVENCY MEASURES
Long-term solvency ratios are intended to address the firm’s long-term ability to meet its obligations, or, more generally, its financial leverage. These are sometimes called financial leverage ratios or just leverage ratios. We consider three commonly used measures and some variations.
Total Debt Ratio The total debt ratio takes into account all debts of all maturities to all creditors. It can be defined in several ways, the easiest of which is this:
Page 61In this case, an analyst might say that Prufrock uses 28 percent debt.3 Whether this is high or low or whether it even makes any difference depends on whether capital structure matters, a subject we discuss in Part 6.
Prufrock has $.28 in debt for every $1 in assets. Therefore, there is $.72 in equity (=$1 − .28) for every $.28 in debt. With this in mind, we can define two useful variations on the total debt ratio—the debt–equity ratio and the equity multiplier:
The fact that the equity multiplier is 1 plus the debt–equity ratio is not a coincidence:
The thing to notice here is that given any one of these three ratios, you can immediately calculate the other two; so, they all say exactly the same thing.