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
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:
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:
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.