As we learned in the previous section, assets and liabilities are part of a company’s balance sheet. In this section, we’ll discuss various formulas derived from the balance sheet that utilize current assets and liabilities in order to determine a company’s liquidity (access to cash).
Current assets typically include cash, cash equivalents (like money markets), accounts receivable, and inventory. Accounts receivable are payments for goods or services the company expects to receive shortly. Basically, if a company has cash or something that can reasonably be turned into cash shortly, it’s considered a current asset. These are the items listed as current assets from the example in the previous section:
Current assets = $125,000
Current liabilities typically include accounts payable, wages payable, taxes payable, and interest payable. All of these relate to bills the company must pay within a short period of time. These expenses relate to the cost of goods, operation costs (general business costs), interest costs on outstanding loans (including bonds), and paying taxes. Basically, if something needs to be paid for within a year, it’s considered a current liability. These are the items listed as current liabilities from the example in the previous section:
Current liabilities = $100,000
The current ratio compares current assets and current liabilities. Companies use this ratio to determine their ability to handle short-term obligations. From a personal perspective, the current ratio would tell you if you could pay off a large bill if it came unexpectedly. If you can, great! If not, you’ll need to consider borrowing some money.
Corporations think the same way. How equipped are they if a large expense comes out of nowhere? The current ratio helps tell that story. This is the formula:
Using the example above, can you calculate the current ratio?
If you were to think about the numbers, it’s always better to have more assets than liabilities. If the current ratio is above 1, the company has more short-term assets than liabilities. If it’s less than 1, the company does not have enough short-term assets to cover its short-term liabilities. This isn’t ideal!
There’s another formula that involves current assets and liabilities. Net working capital doesn’t involve a ratio, but instead provides a specific amount of net assets or liabilities. Here’s the formula:
Using the same numbers as we did above, can you calculate the net working capital?
Instead of providing a ratio, we get a tangible number. If this company were to face an unexpected liability, they have $25,000 of short-term assets that will help them pay for it.
The term ‘quick’ refers to short-term finances. Each of the quick formulas in this section aims to measure the liquidity of a company. The more liquid a company is, the more cash and marketable assets they have on hand. When an unexpected payout is due, liquidity is important.
First, we’ll look at the quick assets formula:
By taking out inventory, the company is only focusing on cash and its marketable assets. If the company is forced to make a sudden, unexpected payout, its inventory probably won’t help (unless it’s very easy to sell its product). The quick assets formula is like looking in the wallet of a company.
There’s also a quick ratio, which is also known as the acid test ratio. This ratio is one of the best ways to determine the liquidity of the corporation because it factors in short-term liabilities as well.
The higher the quick (acid test) ratio, the more liquid a company’s finances are. If the ratio is above 1, the company has enough short-term assets without including inventory to pay off its short-term liabilities. If it’s lower than 1, the company may sell some of its inventory to pay its short-term obligations.
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