Evaluate debt-Understanding Current and quick ratios

MEASUREMENT OF DEBT

There are several measurements you can use to gauge whether a company may be carrying too much debt. Both come off the balance sheet if you want to do the math yourself or you can find the ratios on several online services.

We need two definitions before we move on:

CURRENT LIABILITIES AND CURRENT ASSETS

Current Liabilities are bills that will come due in the next 12 months. These include the company’s normal operating expenses such as salaries, utilities, and so on. Long-term debt, such as mortgages would not be included, however that portion of payments due in the next 12 months would be included.

Current Assets are marketable securities, cash and other assets that can be easily converted to cash within 12 months. Land and real estate do not fall into this category because it often takes longer than a year to sell property.

The term ‘debt’ includes short term liabilities, such as accounts payable, creditors for expenses and taxes payable.These are short term liabilities generated on aren’t really considered as “debts”. Basically, these kind operational liabilities would be there for all companies.

QUICK RATIO

The first ratio is the Quick Ratio. This ratio gives you an idea how easily the company can pay its current obligations – that is those bills due in the next 12 months.

The Quick Ratio is cash, marketable securities and accounts receivable divided by current liabilities (those due in the next 12 months). However, not all Current Assets are included in this ratio – excluded are doubtful accounts receivables and inventory. Basically, you are saying if all income stopped tomorrow and the company sold off its readily convertible assets, could it meet its current obligations?

A Quick Ratio of 1.00 means the company has just enough current assets to cover current obligations. Something higher than 1.00 indicates there are more current assets than current obligations.

It is important to compare companies with others in the same sector because different industries operate with ratios that may vary from one sector to another. Some industries such as utilities, for example carry much more debt than other industries and should only be compared to other utilities.

So, quick ratio is :

  • Current assets – doubtful debtors and inventory / Current liabilities.

It’s also called ‘acid test ratio’ since it takes into account only those assets of the company that can be converted to cash immediately. That’s why even doubtful debtors or debtors which may delay payment are excluded.

CURRENT RATIO

The second ratio is the Current Ratio. The Current Ratio is very similar to the Quick Ratio, but broadens the comparison to include all Current Liabilities and all Current Assets. It measures the same financial strength as the Quick Ratio that is a company’s ability to meet its short-term obligations.

Some analysts like the Current Ratio better because it is more “real world” in that a company would convert every available asset to stay afloat if needed. The Current Ratio measures that better than the Quick Ratio.

Current ratio is computed as follows:

  • Current assets / Current liabilities.

Like the Quick Ratio, a current ration of minimum 1.00 or better is good, and you should always compare companies in the same sector.

CASH RATIO

Talking about liquidity ratios, there is another ratio commonly described in academic texts called cash ratio which measures the liquid cash in hand against the current liabilities of the company. cash ratio is computed by the  equation-

  • Cash balance as shown in balance sheet  / current liabilities

From the investor’s pint of view, only the current ratio is relevant, because nobody is interested in the very short term liquidity measurements of the company. In the very short term, stock movements are more influenced by the demand,  supply and sentiments of the market participants. However, It would be nice to know whether the company is sitting on huge cash reserves or not.

CONCLUSION

These three ratios, which you can find on any Web site that offer quotes, tell you a great deal, about how a company may or may not weather tough times.  Low numbers in these ratios should be a red flag when you are evaluating a stock

You may like these posts:

  1. Understanding interest coverage ratio
  2. Introduction to financial ratios
  3. Understanding price to book ratio

1 Response to “Evaluate debt-Understanding Current and quick ratios”

Gwenelda

September 20, 2011 at 1:26 pm

I wanted to spend a mnitue to thank you for this.

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