A company pays its short-term bills using its short-term resources. A company's ability to pay its short-term bills, which is called its liquidity, is important to its success. You can analyze a company's liquidity using the current ratio and the quick ratio. These ratios are based on information from a company's balance sheet and compare the amount of its short-term resources to the amount of its short-term debts. Higher ratios mean a company is more liquid and has more short-term resources with which it can pay its bills.
1. Find a company's most recent balance sheet in its 10-Q quarterly report or 10-K annual report. The U.S. Securities and Exchange Commission provides public company quarterly and annual reports for free on its EDGAR website (sec.gov).
2. Find the amounts of the company's total current assets and total current liabilities on its balance sheet. Current assets and current liabilities are a company's short-term resources and short-term debts, respectively, that it expects to use up within a year. For example, assume the company's balance sheet shows $250,000 in total current assets and $100,000 in current liabilities.
3. Divide total current assets by total current liabilities to calculate the current ratio. The greater the ratio is above 1, the more liquid the company is. A ratio less than 1 means the company does not have enough current assets to pay its short-term bills. In this example, divide $250,000 by $100,000 to get a current ratio of 2.5. This means the company has 2.5 times as many current assets as current liabilities and has a sufficient amount of liquidity.
4. Find the amount of the company's inventory on its balance sheet, and subtract the amount from the company's total current assets. In this example, if the company's balance sheet shows $100,000 in inventory, subtract $100,000 from $250,000 to get $150,000.
5. Divide the result by total current liabilities to calculate the quick ratio. This ratio excludes inventory from current assets to generate a more stringent, conservative ratio. Inventory may not be as liquid, or convertible to cash, as other current assets. Interpret the ratio similar to the current ratio. In this example, divide $150,000 by $100,000 to get a quick ratio of 1.5. The ratio is above 1, which means the company has sufficient current assets, excluding inventory, to pay its short-term bills.
- Compare the current ratio and quick ratio between companies in an industry to determine appropriate liquidity levels. Different industries operate using different levels of liquidity.
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