The basic premise of liquidity ratio analysis is to show the ability of a company to meet its near-term obligations.
As such, it is one of the cornerstones for measuring the financial health of a company. Thus, it is a more important tool for creditors than for investors.
Below we will dive deeper into the most commonly used liquidity ratios. We will do this through defining the ratio, the formula, how to use it for liquidity ratio analysis and finally, demonstrate the use of the ratio through analysis of Coca Cola and PepsiCo.
Liquidity ratios are closely related to solvency ratio analysis (and in fact many people confuse them).
The difference is, that liquidity ratios measures the short-term ability to pay banks and other creditors. Solvency ratios are more focused on the long term.
After reading this page, you will know whether Coca Cola or PepsiCo are in danger of not being able to meet their near-term obligations
(Hint: Both are doing fine).
Current ratio (or working capital ratio)
The definition of the current ratio formula is:
It shows the ability of a company to meet its short-term liabilities with its short-term assets.
Current ratio analysis
The current ratio is the most basic liquidity test.
It basically shows whether the company can fund its short-term liabilities through the sale of its short-term assets.
This is especially relevant in a liquidation scenario where all assets are sold and what is left is paid, first to the creditors and if anything is left beyond that, the shareholders.
A current ratio higher than one means the company can satisfy its near-term obligations.
A ratio below 1 on the other hand? That means the company cannot pay its near-term obligations.
In this downside scenario, a company will need to raise funds to pay for these liabilities. One way to do this is to sell some of its assets.
However, these assets are used to generate revenue and as such, careful attention and priorities must be taken to decide, which assets to sell.
Current ratio example
Let’s return to our example with Coca Cola and PepsiCo. Given that the two companies are similar we would also expect them to have a current ratio that are alike.
As expected, the current ratio is pretty much the same across both companies.
As both ratios are above 1.0x, both would be able to pay off their short-term liabilities through its balance sheet.
Quick ratio (or acid test ratio)
The definition of the quick ratio / acid test ratio formula is:
It shows the ability of a company to pay off its current liabilities with items that can very easily be converted to cash.
Quick ratio / acid test ratio analysis
The quick ratio is closely connected to the current ratio, but is a tougher test of liquidity.
It does so by taking out items such as inventory and prepaid expenses as those cannot necessarily be easily converted to cash.
The interpretation of the ratio is the same as for the current ratio. A ratio above one is thumbs up and a ratio below one is not necessarily thumbs down, but says, that the company cannot pay its liabilities easily if all operations were stopped.
Quick ratio / acid test ratio example
Previously, we saw that both Coca Cola and Pepsi had a current ratio north of 1.0x.
With the quick ratio, the picture is less clear. Both have for much of the period been below 1.0x and both are now at or very close to the measure.
Does this mean the two companies are about to go bankrupt?
Neither company has much debt and there is nothing indicating, based on the profitability analysis that they are in financial distress.
Times interest earned ratio (coverage ratio)
The definition of the times earned interest ratio formula is:
It shows how able the company is to finance its interest expense with its earnings. It is also sometimes called the interest coverage ratio
Times earned interest ratio analysis
The coverage ratio is quite simple in its premise. It simply shows “how many times” the company is able to pay its interest expenses with its earnings.
A ratio above 1 is needed for the company to be able to pay its interest expenses. A ratio below 1, means that the company will have to need funding besides its normal operations to pay its creditors.
Times earned interest ratio example
So let’s see if Coca Cola or PepsiCo is in financial distress with a ratio below 1.
Coca Cola has a ratio of -10x!
Wow. It must really be in trouble. -10x is way below 1.
That is true.
However, a negative ratio doesn’t make sense in this case as Coca Cola has a negative interest expense. I.e. it has more money in the bank than it borrows and does have a negative interest expense… which is a double negative so it makes money on its interest.
If it had been the other way around, i.e. that EBIT was negative and interest expense was positive it would have signalled big trouble – but that was not the case this time.
PepsiCo also has a very healthy ratio at 9.2x which is not a problem.
Below we have presented the status for both companies.
Had the times earned interest ratio been troublesome, the quick ratio would have been a problem.
However, as we have seen that is not the case and both companies are doing fine and are no way no financial distress.
Now it’s your turn
This concludes our introduction to liquidity ratio analysis.
We encourage you to either try it yourself (that is the best way of learning) or move on to other topics within financial statement analysis, profitability ratios, efficiency ratios or solvency ratios.
We hope you enjoyed it and if you have any comments please post them below.
Or perhaps, you have questions about a step in the process?
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So, if you have a question or a thought, leave a comment right now.