Businesses need to be liquid. They need cash to pay vendors and staff so they can sell their stuff; they need cash to make strategic investments in growth.
Liquidity is huge. It doesn’t matter what kind of business you run. For example…
- A big business (like a manufacturer) needs to pay for its raw materials and marketing before it sells its first product.
- A small business (like a freelance writer) needs to pay his or her bills so they have a computer, word processing app, and internet connection to run their business.
- A real estate investor needs to be able to pursue new deals and to service debt or pay for repairs on a property.
- A capital markets investor needs to be able to invest in that great stock when the price is right.
In some ways (and especially in the early days of running a business), liquidity is more important than profitability. Yes, profitability is important but it doesn’t help if you’re not liquid.
MEASURE YOUR LIQUIDITY WITH THE CURRENT RATIO
So, how can you tell how liquid your business is? The current ratio is a great ratio to use. The current ratio is useful to help you monitor the liquidity of your business, the liquidity of any potential investment you’re going to invest in, and your own personal liquidity.
I should tell you that there are other measure of liquidity — the working capital ratio and the acid test ratio — but the current ratio is my favorite because it’s the easiest to remember while also being pretty accurate. (The other ratios are either less accurate or too complicated or time consuming to be useful).
The ratio goes like this:
Here’s how to understand the ratio:
The two components in the ratio…
- Current assets include anything the business owns that can be converted into cash or used up in the short term — such as cash, short term investments, and accounts receivables. Assets that cannot be quickly converted to cash (such as land and buildings) are not included.
- Current liabilities include anything that needs to be paid within the coming year — such as loans, accounts payables, and income taxes. Liabilities that are longer term (such as mortgages) are not included.
The ratio is derived by dividing current liabilities into current assets.
In simple language, what you’re trying to find out is: How many times does our assets cover our debts?. This tells you how much soon-to-be-cash will pay for your soon-to-be-debts. If you have enough soon-to-be-cash covering your soon-to-be-debts, you’re liquid.
If you don’t have enough soon-to-be-cash to cover your soon-to-be-debts, you’re illiquid. That means, you don’t have enough money to pay your supplies, you don’t have enough money to pay your staff, and you don’t have enough money to market your products. Businesses shut their doors because of liquidity problems!
So let’s look at some examples:
Let’s say you have a lemonade stand and you borrowed $5.00 from your mom to buy lemonade and disposable cups. And let’s say that you sold all of your lemonade and were either paid cash for it or you sold it on account and you’ll send over Bruno your ugly step-cousin to collect if they don’t pay. And in total, you sold $10.00 worth of lemonade.
Your current assets (cash and receivables) are $10.00 and your current liabilities (payables) are $5.00.
Here’s the equation…
And we’ll plug in our numbers…
Current liabilities: $5.00
So our equation looks like this…
To make this equation useful (and as you probably remember from math class), you need to know reduce it down to the lowest reducable denominator:
Now let’s express this equation as a ratio:
Congratulations! You’ve just discovered that the current ratio of your lemonade stand is 2:1.
That means your assets are worth TWICE what your liabilities are worth. It means for every dollar that you owe, you have $2.00. Good… you want to have more assets than liabilities.
But it does happen sometimes that your liabilities are worth more than your assets.
Let’s consider another situation — one that is all too common right now. Let’s say that you have a wallet full of credit cards and each one has a limit of $10,000. Over time, you end up maxing out each card. You only have a $250 in the bank account to get you through to next payday.
Plugging these numbers into the equation…
That reduces down to:
In other words, for every just-over-half-a-cent of current assets, you have a dollar of current liabilities. Yikes! I just threw up a little in my mouth. And if your brother-in-law calls you up and needs bail money fast, you won’t be able to help him.
Current ratio is important so valuable no matter whether you’re a business owner or investor or someone who wants to manage your finances a bit better.
If you are a business owner, this is an easy metric to calculate to monitor your liquidity. Just find out what your current assets are (that’s easy because you probably know what your cash on hand and your accounts receivables are) and divide that by your current liabilities (probably all of your payables and maybe any other short term loans you have).
Let’s look at a few business’ balance sheets to get some numbers and make our calculations. (I’m using some numbers from the balance sheets published in Yahoo Finance).
Apple (APPL) (From their annual balance sheet, published September 23, 2011)
Current liabilities: $27,970,000,000
So their current ratio is: 1.61:1
Therefore, Apple has 1.61 dollars of current assets (soon-to-be-cash) to cover every dollar of current liabilities (soon-to-be-debts).
Here’s another one:
Everyone loves to hate Research In Motion (RIMM) (From their annual balance sheet, filed March 2, 2012)
Current liabilities: $3,389,000,000
Their current ratio is 2.02:1. Even though they are much smaller and more repulsive than Apple, they can cover each dollar of short-term debt with $2.02 of current assets, which is better than Apple’s ratio of 1.61:1.
Or, let’s take Berkshire Hathaway (BRK-A) (From their annual balance sheet, published December 30, 2011)
Current liabilities: $32,706,000,000
So their current ratio is 2.42:1. In other words, for every dollar that they owe in the coming year (debt obligations, income tax, etc.), they can cover it with $2.42 in easy-to-convert-to-cash current assets.
Here’s one more that you might find interesting:
American Electric Power Company (AEP) (From their annual balance sheet published December 31, 2011)
Current liabilities: $6,611,000,000
Their current ratio is 0.63:1.
That’s right! For every dollar of current liability (of short term loans) they have only $0.63 of current assets. Now, it might not be the end of the world (and with utilities, people are pretty reliant on them so they’re pretty entrenched even if the owe money).
Want to learn even more? Here’s a useful video that lays it out nicely for you. This one is good if you’re a business…
… and this video is good if you’re an investor…
If you’re a business owner, your current ratio is easy to measure and will help you to see if you have the liquidity to pay your financial obligations.
If you’re an investor, you can use the current ratio of potential investments to make sure that they are liquid enough to stay in business and continue selling stuff.
A FEW MORE THINGS TO NOTE
- There are many ratios to use. Current ratio is just one of them and you shouldn’t use it as the ONLY measure.
- I’ve given numerous examples above from different industries. But it’s important to remember that if you want to compare businesses, you should really compare businesses from the same industry. It’s not useful to compare a company from one industry to a company from another industry because what’s healthy in one industry might not be healthy in another.