Liquidity: can the company pay its bills?

What is liquidity?

A company can make a profit and still get into trouble if money comes in too late. Liquidity compares what turns into cash within the year (stock, receivables, money in the bank) with what has to be paid within the year (suppliers, taxes, wages, short-term loans).

It is a snapshot on the balance sheet date. A seasonal business, such as an ice cream maker or a toy shop, can look very different on another day of the year.

The two formulas

The quick ratio leaves out stock, because it cannot always be sold quickly or at full value. It is therefore also called the acid test. For trade and manufacturing with a lot of stock, the gap between both ratios is large; for a service company without stock, they are equal. The item numbers follow the Belgian format of the annual accounts, which builds on the European Accounting Directive.

Example: Bakkerij De Zoete Korst

The fictitious bakery has €190,000 of current assets: €45,000 of stock (flour, packaging, finished goods), €85,000 to collect from customers and €60,000 in the bank. Within the year it has to pay €150,000: €30,000 of loan repayments, €70,000 to suppliers and €50,000 of taxes, wages and social security.

1. Step 1

   Current ratio

   Divide all current assets by short-term debt.

   €190,000 ÷ €150,000 = 1.27
2. Step 2

   Quick ratio

   First subtract stock, then divide again.

   (€190,000 − €45,000) ÷ €150,000 = €145,000 ÷ €150,000 = 0.97

Including stock, the bakery can pay its short-term debt 1.27 times. Without stock it drops just below 1. For a bakery that is less worrying than it looks: bread and pastries sell every day, so stock turns over quickly.

What is a good current ratio?

Rules of thumb Nummo uses for the current ratio:

• Below 1: fewer current assets than short-term debt. The company relies on new income or credit.
• Between 1 and 1.5: enough, but tight.
• Between 1.5 and 3: healthy.
• Above 3: more than enough. Safe, but a lot of money may be sitting idle.

For the quick ratio, 1 is the benchmark. These remain rules of thumb that differ by sector. A supermarket receives cash from customers and pays suppliers later, so it often runs below 1 without problems. A construction company with long payment terms needs more of a buffer.

What to watch out for

• Receivables count at their full amount, even if a customer may not pay.
• A credit line the bank keeps open makes a low ratio less worrying. You cannot see that in the annual accounts.
• Look at working capital as well: the ratio says how many times, working capital how many euros of buffer.

Calculate it yourself

Want the current ratio of another company? Then enter the three figures from its annual accounts. The fields start with the bakery example.