[MUSIC PLAYING] This is Dr. Bob Nolley. And welcome to this lesson on liquidity ratios. Remember, that the concept of liquidity represents the ability of a company to repay its short-term creditors out of the cash that it has. And this liquidity could be represented by a ratio that we developed by comparing assets to liabilities. And there are a couple of ways we can do this.
One is with the current ratio. And the other is with the quick ratio. First, the current ratio.
The current ratio measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares the current assets to the current liabilities. These current assets are an asset that can be converted to cash or used to pay current liabilities within the coming year.
Current assets are usually cash, cash equivalents, short-term investments, accounts receivable and inventory. Current liabilities are often represented by all of the liabilities that an organization has to be settled in cash within the next year. The current ratio is found by dividing the current assets by the current liabilities.
An acceptable current ratio varies from industry to industry, but they're generally between 1 and 1/2 and 3 for a healthy business. For companies with a ratio in this range, it generally indicates good short-term financial strength. Let's take a look at an example.
Here we have the balance sheet of our fictitious ABC Company. What are its current assets? Well, its total current assets are $12,874. What are its current liabilities? Current liabilities are $12,409.
Now if we divide the current assets by the current liabilities, we get 1.05. This seems a little bit low. The company can barely repay its current liabilities from its current assets. Now, let's take a look at another measure.
The quick ratio or the acid test measures the ability of a company to use its cash or quick assets to retire its liabilities immediately. This is also known as the acid test. We calculate this by dividing the current assets minus the inventory by the current liabilities. The reason for excluding the inventories is this, cash and cash equivalents are the most liquid assets found in the current asset portion of the balance sheet. And among the ones that could be most quickly converted.
And we could include accounts receivable among those as well. But inventory is something that could take a little bit longer to convert. So they would not be able to be immediately available to repay the current liabilities. Let's take a look at our company again.
We said that ABC Company has current assets of $12,874. But if we subtract the inventory of $5,560, then we only have cash left of $7,314. If we divide that by the current liabilities of $12,409, we have a quick ratio of 0.59. This shows that we don't nearly have enough coverage to take care of our current liabilities in the short-term.
Here are some key takeaways from this lesson. Liquidity is the ability of an organization to pay its current liabilities with its current assets. We can measure this with the current ratio, which is current assets divided by current liabilities. And generally, this should be between 1 and 1/2 and 3 for a healthy business. Can the current ratio be too high?
Well, if you're a shareholder and the current ratio is 4, are you happy because they are so liquid? Most likely you would want that number to be lower, because this means there's cash sitting there not being invested in growth or paid out by dividends. The second measure that we look at is the quick ratio. This removes the inventory from the current assets.
The quick ratio should be one or higher. But this can vary.
This is Dr. Bob Nolley. And I'll see you in the next lesson.
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