As you saw in the previous section, assets and liabilities appear on a company’s balance sheet. Here, we’ll use balance sheet information - especially current assets and current liabilities - to calculate common measures of a company’s liquidity (its access to cash in the near term).
Current assets typically include cash, cash equivalents (like money market holdings), accounts receivable, and inventory. Accounts receivable are payments for goods or services the company expects to collect soon. A good rule of thumb is: if the company already has cash, or can reasonably convert the item into cash within a short period of time, it’s 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. These are obligations the company expects to pay within a short period of time. They can come from the cost of goods, operating costs (general business costs), interest costs on outstanding loans (including bonds), and taxes. A good rule of thumb is: if it must be paid within a year, it’s 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 to current liabilities. Companies use it to estimate how well they can handle short-term obligations.
A personal analogy can help: if a large bill showed up unexpectedly, could you pay it with the cash (or near-cash) you have available? If not, you’d likely need to borrow. Companies face the same question, and the current ratio helps answer it.
This is the formula:
Using the example above, can you calculate the current ratio?
If the current ratio is above 1, the company has more short-term assets than short-term liabilities. If it’s below 1, the company doesn’t have enough short-term assets to cover its short-term liabilities, which is generally not ideal.
Another measure that uses current assets and current liabilities is net working capital. Unlike a ratio, net working capital gives you a dollar amount showing the net short-term resources available.
Here’s the formula:
Using the same numbers as above, can you calculate net working capital?
Instead of a ratio, you get a tangible number. In this example, if the company faced an unexpected short-term obligation, it would have $25,000 in net short-term assets available to help cover it.
The term “quick” refers to short-term finances. Each quick formula in this section measures liquidity - how much cash and other marketable assets the company has available. Liquidity matters because when an unexpected payout is due, the company needs resources it can use right away.
First, we’ll look at the quick assets formula:
By subtracting inventory, this measure focuses on cash and other assets that are typically easier to convert into cash quickly. If the company needs to make a sudden payout, inventory may not help much (unless the company can sell its product very quickly). You can think of quick assets as a snapshot of what’s in the company’s “wallet.”
There’s also a quick ratio, also known as the acid test ratio. This ratio is a common way to evaluate liquidity because it compares quick assets to short-term liabilities.
The higher the quick (acid test) ratio, the more liquid the company is. If the ratio is above 1, the company has enough short-term assets (excluding inventory) to pay off its short-term liabilities. If it’s below 1, the company may need to sell some inventory to meet its short-term obligations.
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