Example 31 I

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.

Entrepreneurial Edge (edge.lowe.org) provides educational information aimed at smaller, newer companies. Follow the "money" link to read about financial statements.

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:

Quick ratio

Current assets - Inventory Current liabilities

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 in 2002 was:

Quick ratio

.53 times

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.

To give an example of current versus quick ratios, based on recent financial statements, Wal-Mart and Manpower Inc. had current ratios of .92 and 1.60, respectively. However, Manpower carries no inventory to speak of, whereas Wal-Mart's current assets are virtually all inventory. As a result, Wal-Mart's quick ratio was only .18, whereas Manpower's was 1.60, 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:

Cash

Cash ratio

Current liabilities

You can verify that for 2002 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:

Net working capital to total assets

Net working capital 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:

Interval measure

Current assets

Average daily operating costs

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

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