The Liquidity Trap

Sometimes financial calculations are not what they at first seem. That is, we may not be able to take them at face value. I previously discussed a little about what financial analysis can do for you in Things Financial Analysis Can Tell You. In that post two things mentioned were the current ratio and the quick ratio. Let’s look at these a little closer. To do this we’ll use the sample Balance Sheet below, define current ratio and quick ratio and then discuss what I refer to as the liquidity trap.

current and quick ratio
Current Ratio

The current ratio is the total current assets divided by the total current liabilities. It is intended as a measure of a company’s ability to meet obligations that must be paid over the next 12 months. In the example above, the current ratio is calculated as:

1,400,000 / 200,000 = 7

That is saying that the current liabilities are covered 7 times by the current assets. That would make it appear that the company’s liquidity is strong and it should be able to cover the current liabilities easily. Now let’s get a little more definitive of this ability.

Quick Ratio

The quick ratio is the ratio of quick assets (in this case Cash and Marketable Securities plus Accounts Receivable) divided by the total current liabilities. The quick assets are ones that are either cash or considered readily convertible to cash. It is viewed as a better indicator of a company’s ability to meet obligations over the next 12 months. For the balance sheet above the quick ratio is calculated as:

(100,000 + 500,000) / 200,000 = 3

Again this would appear to be a strong indicator of the company’s ability to meet obligations over the next 12 months. But we should not assume that just yet.

The Liquidity Trap

Despite the strength of the company as shown by the current and quick ratios, we need to dig a little deeper. Imagine that the accounts receivable balance of $500,000 has many accounts that are extremely past due. Assume the breakdown of this to be: $50,000 is current, $20,000 is 31 to 60 days past due, $5,000 is 61 to 90 days past due, $5,000 is 91 to 120 days past due, and the remaining $420,000 is anywhere from 121 days to over a year past due. I have used these numbers to make ir easier to see that both the current ratio and quick ratio need to be looked at a little closer to see just how strong the liquidity actually is. Now imagine that upon closer examination we determine we can only be expected to collect $120,000 of the $500,000 that is over 121 days past due. That means that of the total $500,000 in accounts receivable we can only realistically expect to collect $200,000 and some of that is going to take some time. Now let’s recalculate the current and quick ratios using this assumption.

Current ratio = (1,400,000 – 300,000) / 200,000 = 5.5

Quick ratio = (100,000 + 200,000) / 200,000 = 1.5

You can readily see that the liquidity is drastically reduced. Since the quick ratio is really a better indicator of liquidity, we can see that the problems with accounts receivable collections has cut this ratio is half. The company is not nearly as liquid as we may have initially thought.

This is the danger of taking any financial calculation at face value. It is vital to dig a little deeper. In the example above the liquidity trap is that when only the initial calculations are considered it is easy to be deluded into thinking everything is okay.

If you are not sure of how to interpret these or other financial calculations, AimCFO is ready help.

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As always, your comments are welcomed.


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