Credit Insights 01/22: Optical retailers – poor working capital management drives leverage up
28. February 2022.What is the purpose of the current ratio and the quick ratio, and when are they used?
The purpose of the current ratio and the quick ratio is to assess to what extent can a company cover its short-term liabilities by liquidating its current assets.
These ratios are a part of a wider set of ratios used in financial / credit analyses, i.e., when assessing a company’s creditworthiness. Liquidity ratios are more important in the analysis of companies with a weaker credit rating, where the focus of the analysis is on the short-term (normally the following twelve months). In addition, these ratios are sometimes used as financial covenants in lending agreements, whereby lenders demand maintaining a certain level.
How are they calculated?
- Current ratio = Current Assets / Short-term Liabilities
- Quick ratio = (Current Assets – Inventories) / Short-term Liabilities
What are their key advantages?
The main advantage of these ratios is their simplicity. Already at a first glance on the balance sheet it is possible to get a view on the company’s liquidity. However, such view is often wrong.
What are their key disadvantages?
There are five key disadvantages of these ratios.
1) The ratios do not say anything about the quality of assets
The numerator in the calculation of both ratios includes items like inventories (valid only for the current ratio!), trade receivables, other receivables, current financial assets, and cash and cash equivalents. However, all these types of assets can have different degrees of quality. For example, inventories differ in their marketability, because it is not the same whether it is about raw materials, semi-finished goods, or finished goods. Trade receivables also have a different degree of default risk because customers’ credit ratings differ, and they pay in different terms. Receivables can also be in different currencies and thus contain an FX risk. Financial assets can differ in terms of marketability too because loans to other companies, investments in securities and deposits at banks are not all of the same quality and liquidity. Finally, cash might be restricted by specific contractual clauses or if it is located in jurisdictions from which the money cannot be withdrawn without significant expenses. On the other hand, short-term liabilities are most often real and represent expected cash outflows over the next twelve months (with the exception of some pure accounting items).
2) Standard formulas include items which can distort results
In its numerator, the current ratio includes inventories, which also account for non-current assets held for sale. So, for example, the building the company intends to sell can significantly improve the liquidity assessment, although the building’s marketability can be questionable. In addition, financial statements often include deferred income under short-term liabilities, which can relate to e.g., long-term subsidies from EU funds. It is also important to mention that differences in accounting standards can impact the comparability of ratios between companies.
3) These ratios ignore industry specifics
Many books covering financial statements analysis often recommend that the current ratio and the quick ratio should amount to above 2x and 1x, respectively. However, it’s not the case in practice. Namely, every industry has its own asset conversion cycle, where a market strength of a company also plays a significant role. For example, food retailers, airlines, hotel operators, etc., often have structurally negative working capital, i.e., trade payables exceed the value of inventories and trade receivables, leading to short-term liabilities being higher than current assets.
4) These ratios are calculated on a specific day, and they can be highly volatile throughout the year
Financial statements are normally available only with a delay, often even six months after the financial period has ended. This means that the current ratio and the quick ratio say what the liquidity (conditionally speaking!) was like at the balance sheet date. It is highly probable that the ratio value changed in the meantime, and the values can significantly differ with companies having a pronounced seasonality of business operations. For example, the liquidity of hotels in Croatia will often be higher during the tourist season when the cash inflows are concentrated, rather than at the end of December when the financial year ends for most of them.
5) The current and the quick ratio are susceptible to manipulation
The current and the quick ratio can be heavily manipulated by deliberate misclassifications aimed at showing the company’s liquidity better than it really is. For example, inventories, trade receivables, and financial assets might not be valued in line with accounting standards, companies can deliberately reclassify certain non-current assets as available for sale although there is no real intention to sell those assets, short-term debt can be misclassified as long-term debt, etc. These are just some of the common examples. These manipulations can significantly impact the company’s ability to comply with financial covenants, and creditors should be careful how they define relevant terms and definitions in their lending agreement.
When and how to use the current and the quick ratio?
The quality of these ratios is in practice very low, and the ratios do not adequately represent the company’s liquidity. They have to be used carefully, and only in exceptional situations like trend analyses and peer group comparisons. But even then, the results should be taken with a pinch of salt given their limited value. The general recommendation is to exclude these ratios from the rating models, decision-making processes, and managers’ KPIs due to significant shortcomings stated above.
What are the alternatives to these ratios?
There are two viable alternatives to these ratios: (1) alternative liquidity ratios, and (2) alternative liquidity calculation models.
(1) In practice, the ratio (Cash + Available credit lines) / Short-term debt has proved to be a better measure of a company’s liquidity. The ratio says how much of the short-term debt can be covered by available cash and credit lines. Ideally, this ratio should be combined with working capital and balance sheet structure ratios.
(2) The other alternative is a different model to calculate liquidity, derived from financial statement projections. This option is more demanding, but also the only right way to assess the company’s liquidity. We will cover it in one of our upcoming articles.
If you would like to know more about the topic and how to apply it in your company, feel free to get in touch by e-mail to mario@creditanalyst.eu, the contact form on https://creditanalyst.eu/en/contact/, or call us on +385 98 920 17 13.
