3.03 – Judging Liquidity & Solvency
Judging Liquidity and Solvency
Solvency is the ability of a business to pay its liabilities on time. Delays in paying liabilities can cause significant problems for a business, including the risk of involuntary bankruptcy. Even the threat of bankruptcy can severely disrupt normal operations and impact profit performance. While liquidity isn’t a well-defined term, it generally refers to a business’s ability to maintain adequate cash balances and cash flows to avoid disruptions caused by cash shortfalls.
If current liabilities become too high relative to current assets, which are the primary defense for paying current liabilities, managers should act swiftly to address the issue. A perceived shortage of current assets relative to current liabilities can raise concerns among creditors and owners.
Consider the following points in Figure 3-2 (dollar amounts refer to year-end 2020):
- Current assets: The first four asset accounts (cash, accounts receivable, inventory, and prepaid expenses) total $22.222 million in current assets.
- Current liabilities: The first four liability accounts (accounts payable, accrued liabilities and other, current portion of debt, and other current liabilities and deferred revenue) total $4.963 million in current liabilities.
- Notes payable: The total interest-bearing debt is divided between $1 million in short-term notes payable (due in one year or less) and $6.25 million in long-term notes payable and other long-term liabilities (due after one year).
Read on for details on current assets and liabilities, and the current and quick ratios.
Current Assets and Liabilities
Short-term, or current, assets include:
- Cash
- Marketable securities that can be immediately converted into cash
- Assets converted into cash within one operating cycle, such as accounts receivable and inventory
The operating cycle involves putting cash into inventory, holding products in inventory until they’re sold, selling products on credit (generating accounts receivable), and collecting the receivables in cash. The cycle duration varies from a few weeks to several months, depending on the business.
Short-term, or current, liabilities include non-interest-bearing liabilities from operating activities. Businesses usually maintain many accounts for these liabilities, with separate accounts for each vendor. An external balance sheet typically shows three or four operating liabilities, and it’s understood that these don’t bear interest unless overdue.
In addition to operating liabilities, the current liabilities section includes interest-bearing notes payable due within one year and other liabilities that must be paid in the short run.
Current and Quick Ratios
The sources of cash for paying current liabilities are the company’s current assets, which consist of cash and assets to be converted into cash soon.
The current ratio sizes up current assets against total current liabilities. Using information from the balance sheet (refer to Figure 3-2), the year-end 2020 current ratio is calculated as follows:
Current Ratio=Current Assets / Current Liabilities=$22.222 million $4.963 million=4.48
Businesses often leave it to the reader to calculate this ratio, though some may include it in a financial highlights section.
The quick ratio is more restrictive, including only cash and assets that can be immediately converted into cash. For the business in this example, the quick ratio is calculated as follows:
Quick Ratio=Quick Assets / Current Liabilities=$20.164 million / $4.963 million=4.06
While folklore suggests that a current ratio should be at least 2.0 and a quick ratio 1.0, acceptable ratios vary by industry. Lower ratios don’t necessarily indicate an inability to pay short-term liabilities on time.
