Meaningful Metric July 2021 | In Times Like These, It Pays to Be Quick

As we emerge from the COVID-19 pandemic and deal with subsequent supply-chain disruptions, every business must take stock of its liquidity – and avoid misconceptions about its short-term financial position. This is particularly true of small- and mid-sized businesses (SMBs) that often lack a general line of credit or other ready sources of funding.

The most prevalent liquidity statistics used by companies, banks, and investors are the current ratio and net current assets. Simply put, these statistics compare GAAP-defined current assets to current liabilities. Unfortunately, however, the current ratio falls short as a predictor of potential financial stress for many reasons.

Current assets include inventories, prepaid expenses, and other assets that cannot be predictably converted to cash and used to pay an organization’s near-term obligations (such as trade payables and accrued expenses).

Enter the quick ratio. This liquidity ratio is aptly named because it only considers the portion of current assets that can quickly be converted to cash and used to pay current liabilities. 

The ratio is generally calculated as:

Cash and equivalents, marketable securities, and current accounts receivable

Divided by:

Accounts payable, accrued liabilities, and other current liabilities

As a starting point, most companies maintain a quick ratio of at least 1.0, meaning quick assets at least equal current liabilities. In the most general terms, the implication is that as liabilities come due, the company can expect to have funds ready to pay those liabilities. A ratio of 1.5 or higher is, of course, safer.

In evaluating the quick ratio’s implications, several questions must be addressed:

• What terms have been extended to customers? Do historical payment patterns adhere to those terms? If payment terms are short (e.g., net 30 days with no significant delinquency), liquidity may be stronger than the quick ratio indicates. However, if terms are longer or if some customers are facing financial strain, a seemingly strong quick ratio may not be sufficient.

• What terms does the company have with its vendors? Ideally, a company would sell to its customers on the same, or perhaps shorter, terms than its vendors provide. This is particularly true when trade payables and accounts receivable dominate the quick ratio. If a company has little cash or cash equivalents but must pay its vendors much sooner than it expects to collect from customers, it may need to plan for a liquidity squeeze.

After the quick ratio is calculated and any subjective factors are considered, the company should consider whether to seek short-term financing to bridge any potential gap between its payments and its collections.

While there are many forms of short-term financing, availability will depend upon the financial condition and size of the company. Some of the more common alternatives available to SMBs include:

• Invoice Discounting: Provides for immediate payment for well-substantiated accounts receivable. The cost is higher than factoring but should be manageable if used infrequently.
• Factoring or Asset-Based Lending: Used when there is a significant and ongoing liquidity need. Often the factor or ABL lender collects the accounts receivable on behalf of the compa­ny as a condition of the financing.

Evaluating, and potentially improving, liquidity is an ongoing process that’s essential to the financial health of any company. Knowing that near-term obligations can be serviced by quick assets or through a short-term financing facility will let the SMB owner sleep well at night and provide the confidence needed to grow the business.