5.4: Liquidity Ratios

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Video - Audio - YouTube (Liquidity Ratios start on slide 28.)

The Liquidity Ratios are financial ratios concerned with a firm’s ability to meet its day-to-day operating expenses and satisfy its short-term obligations as they come due. These ratios ask critical questions: Can the company meet payroll? Can they pay the bills that are due? Are they in danger of being forced into bankruptcy? These ratios use entries from the Balance Sheet.

Current Ratio

The Current Ratio is a very popular ratio. It compares the Current Assets with the Current Liabilities. Recall that accountants use the term current to mean any assets or debts that are due within one year.

Current Assets Current Ratio = ————————————————————— Current Liabilities

The Current Ratio is a good indicator of how stable a company is. Anything over 1.0 is normally considered acceptable. If your Current Assets equal or exceed your Current Liabilities, you should be able to satisfy your short-term obligations without any problems. Obviously, the greater the number is, the better. On the Balance Sheet of Sprouts, we see that the Current Assets are 673,800 and the Current Liabilities are 522,380. The resulting Current Ratio for Sprouts is 1.290. This is above 1.0 and indicates that Sprouts is able to pay its short-term debts. We don’t have to worry about them not being able make payroll or being hauled off to bankruptcy court.

Net Working Capital

Net Working Capital is the one oddball in our group. It is not a ratio. Instead of dividing, we subtract. It is the result of subtracting the Current Liabilities from the Current Assets. In essence, it is the Current Ratio in absolute dollar terms. Net Working Capital is often discussed when discussing the Current Ratio and our next liquidity ratio, the Acid-test Ratio, but it is not as popular as the two ratios.

Net Working Capital = Current Assets - Current Liabilities

If the Current Ratio is greater than 1.0, then Net Working Capital will be positive since Current Assets will be greater than Current Liabilities. Conversely, if the Current Ratio is less than 1.0, then Net Working Capital will be negative. The higher the Net Working Capital, the better. This statistic is less popular than the Current Ratio. Since the Current Ratio of Sprouts is 1.290, we should expect their Net Working Capital to be positive. Taking the Current Assets of 673,800 and subtracting the Current Liabilities of 522,380 gives us a positive 151,420 for the Net Working Capital. Remembering that all numbers are in thousands, this means their Current Assets exceed their Current Liabilities by more than $151 million dollars. For their size, Sprouts has plenty of Net Working Capital and is in no danger defaulting on its short-term obligations.

Acid-test Ratio, also known as the Quick Ratio

What a great name, the Acid-test Ratio! The Acid-test Ratio is a stricter version of the Current Ratio. For the Acid-test Ratio, we remove the Inventory from the Current Assets.

Acid- Cash + Accounts Receivables + Short-term Investments + Other Current Assets -test = ————————————————————————————————————————————————————————————————————————————— Ratio Current Liabilities

Unlike the Current Ratio, the Acid Test Ratio excludes inventory. This ratio measures the ability of the company to meet its short-term obligations even if its current inventory becomes obsolete or undesirable and hence, difficult or impossible to be turned into cash. Anything greater than 1.0 is considered adequate. It is also called the Quick Ratio. (We don’t know where the name Quick Ratio came from but it certainly reminds us of one of the early founders and eventually the third CEO of the Intel Corporation, Andrew Grove, who loved to say that there were only two types of companies, the Quick and the Dead. He also used to quip that, “only the paranoid survive.” Mr. Grove was instrumental in building Intel into the world’s largest semiconductor company.)

An easier form of the Acid-test Ratio formula is:

Acid- Current Assets - Inventory -test = ———————————————————————————— Ratio Current Liabilities

We will take the easier route to calculate the Acid-test Ratio for Sprouts. The Current Assets of 673,800 minus the Inventory of 310,550 gives us a numerator of 363,250. Dividing the numerator of 363,250 by the Current Liabilities of 522,380 gives us an Acid-test Ratio of 0.695. This number is more concerning than the Current Ratio. We need to take a good, long look at the Inventory for Sprouts and ask if there is a danger of the Inventory becoming obsolete or otherwise undesirable. We would combine that analysis with another ratio that we will discuss below, the Inventory Turnover, to determine if this is something that should give us pause. At first blush, though, we might intuitively surmise that the majority of products that a grocery such as Sprouts carries are not going to become obsolete or otherwise undesirable barring any natural catastrophe. Everybody got’s t’ eat, right?