This is a four-part online series on financial statement basics adapted from an article on credit and finance in the July-August 2022 issue of Produce Blueprints. To read the full issue online, click here.

Liquidity ratios measure a company’s short-term ability to pay maturing obligations and unexpected cash needs. The liquidity ratios on the balance sheet include the current ratio and the quick ratio.

A position closely related to the current ratio is working capital, which is total current assets minus current liabilities. Working capital shows how much current assets are greater or less than current liabilities.

A positive working capital position is when current assets exceed current liabilities, which is preferable.

In Table 2, the working capital figure as of December 31, 2021 is \$295,000 minus \$160,000, which equals \$135,000.

Current Ratio
The current ratio expresses the relationship between current assets and current liabilities, by dividing current assets by current liabilities.

The current ratio for Table 2 as of December 31, 2021 is \$295,000 divided by \$160,000, or 1.84:1. This means that for every dollar of current liabilities, the company has \$1.84 of current assets.

The current ratio is a measure of liquidity, but does not take into account the composition of current assets. For example, it would not identify slow-moving inventory or slow-to-convert accounts receivable.

A positive working capital position and general liquidity ratio are preferable. As mentioned, asset mix is ​​sometimes an important factor when assessing liquidity.

A negative working capital or current ratio suggests that a company may be having difficulty paying its maturing obligations.

Quick report
Another liquidity ratio is the quick ratio, calculated by taking cash, marketable securities and accounts receivable and dividing by current liabilities.

The quick ratio in Table 2 as of December 31, 2021 would be cash of \$90,000 plus accounts receivable of \$200,000 divided by current liabilities of \$160,000, or 1.81:1.

Depending on how a business operates and its current asset mix, a less than one relationship with current liabilities is entirely possible.

The value of the quick ratio is that it shows cash and assets that can be converted into cash in about 30-90 days.

In most cases, the Quick Ratio will be lower than the Current Ratio, given what each represents. Comparing the two ratios is also an important step – it provides some context and offers an indication of financial trends.

For example, in Table 2, the current and rapid 2020 ratios are 1.78:1 and 1.74:1, respectively. Each of the 2021 liquidity ratios is higher than the 2020 ratios, indicating a positive direction.

If the business operated efficiently in 2020 with such ratios, it is reasonable to assume that it performed consistently or better in 2021.

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