Most companies go bankrupt because they run out of cash. Liquidity ratios measure this risk.
Current Ratio and Quick Ratio
Current Assets – Inventory
The Current Ratio – Current Assets, divided by Current Liabilities – asks a question on behalf of a company’s suppliers: will this company be able to pay me if it needs to close down? In that scenario, will its short-term Assets be sufficient to pay off its short-term Liabilities (including those owed to me as a supplier)?
Suppliers like to see high liquidity ratios. Would that same preference be true for shareholders? Why or why not?
For shareholders, greater liquidity creates a tradeoff. Yes, they want to ensure that the company doesn’t go bankrupt. But, highly liquid assets, like cash, may not provide such a great return.
The Quick Ratio corresponds to the Current Ratio, but excludes Inventories. Why?
Let’s think about three different companies: Rio Tinto Group, a global mining and metals corporation; NuCor Corporation, a “mini-mill” steel producer; and Burberry, a luxury fashion house. For each of those, which ratio would you prefer to see – the Quick Ratio or the Current Ratio?
This question hinges on which company you think has the riskiest inventory. In many ways, Burberry is likely to have the riskiest inventory because there is no spot market available for it to liquidate its inventory on – and if it makes a stylistic mistake on a new product, it may be impossible to sell that inventory, even at a discount. By contrast, Rio Tinto and perhaps NuCor may be more able to dispose of their inventory quickly.