Cash is sanity, profit is vanity! In the recent Chapter 2, we learned about working capital. Let us now convert that concept into a ratio. Liquidity ratios are used to calculate the ability of the company to pay its short-term bills and stay solvent.
When considering a business loan application, the banks aren't always most concerned about how profitable the business is. Rather, they're more concerned about whether or not the business has sufficient liquidity (cash or things that turn into cash quickly) to pay their upcoming bills.
We use two ratios to measure this survival ability:
This is the most common measure of short-term financial health. Your current assets (cash, inventory, receivables) compared to your current liabilities (bills and debts due in the next 12 months).
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]The Current Ratio is very solid, but it has a defect: it includes Inventory. Imagine possessing a warehouse filled with winter coats, but at the same time, it is summer. You cannot make rent payments using winter coats. The Quick Ratio omits inventory from the calculation, offering a far stricter assessment of financial survival.
\[ \text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} \]A firm having a respectable current ratio and an awful quick ratio means it has too much cash trapped in unsold goods on the shelf.
Gaining insight into liquidity gives you the power to spot a business crisis months before it actually occurs. By examining a balance sheet and calculating these two ratios, one can quickly determine whether a company is likely to encounter difficulties in meeting its payroll obligations the following month. It's time to do your risk assessment!