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http://TheValueatRisk.blogspot.com
 
November
 
10,
 
2009
 
Liquidity
 
Analysis:
 
Current
 
Ratio
 
and
 
Quick
 
Ratio
 
In the first installment of my liquidity analysis discussion, I coveredNet Working Capital; whichis defined as Current Assets minus Current Liabilities. There are two additional ratios thatshould be a part of investor's liquidity analysis: the current ratio and the quick ratio. Both thecurrent and the quick ratio are calculated entirely from the "current" section of the balancesheet. To refresh, current assets are cash, short term investments, receivables, inventory, orany other asset that the company expects will be converted to cash within a year or less.Current liabilities are accounts payable, expenses that accrue on a regular basis like wages,short term notes, and the portion of long term debt due within a year or less. The "due in oneyear or less" is a consistent theme which applies to current liabilites. To illustrate this distinction,I've included Intel Corporation's (INTC) consolidated balance sheet (2006-8) below:
 
http://TheValueatRisk.blogspot.com
 
November
 
10,
 
2009
 
Although not entirely scientific, I like to think of current assets and current liabilities as thecorporation's revolving door; these portions of the balance sheet are turning over constantlybetween reporting periods. In contrast, non-current assets like buildings and machinery arerelatively immutable
,
 
as are the portions of debt which mature many years down the road. In
 
http://TheValueatRisk.blogspot.com
 
November
 
10,
 
2009
 
that sense, a corporation could own every parcel of land on the east coast, but without theliquidity contained in current assets, might conceivably be unable to pay it's bills or service it'sdebt. The previous example, although extreme, underscores the importance of applying both ofthe following ratios during your analysis of financial statements.
Current Ratio
 The Current Ratio is simply current assets divided by current liabilities. The point is basically tomeasure how many times the firm's current assets can cover it's current liabilities. I'll use thefigures from Intel's 2008 balance sheet to calculate it's current ratio.Intel's Current Ratio = Current Assets / Current Liabilities= $19,871M / $7818M= 2.54Generally, a current ratio above 1 is indicative of a strong current liquidity position. At 2.54, Intelappears to have more than sufficient liquidity necessary to cover it's payables and other shortterm debts coming due within the year.
Quick Ratio
 I think of the quick ratio as a more precise glimpse into the firm's liquidity position. It basicallymeasures whether the corporation could, if needed, quickly pay down all of it's current liabilities.The calculation here is Cash/Cash Equivalents divided by Current Liabilities. Below is acalculation of Intel's quick ratio for 2008:Intel's Quick Ratio = Cash and Cash Equivalents / Current Liabilities= $6512M / $7818M= 0.83To verbalize Intel's quick ratio, I'd say that Intel has 83% of the cash necessary to fund it'scurrent liabilities. This is actually a relatively healthy quick ratio, and isn't expected to be greaterthan 1. Furthermore, if you look at the rest of Intel's current assets, you'll see $5331M worth ofShort Term Investments. As Intel cashes out these investments over the subsequent twelvemonths, it will have substantially more cash than necessary to meet it's short term liquidityneeds.As usual, it's important to monitor how these ratios change over time, as it will illustrate whetherthe firm is becoming more - or less - liquid with the passage of time. In the current environment,it should be obvious which way you'd like to see these measures trending.*no positions
Copyright
 
2009
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