Page 121 - Finance for Non-Financial Managers

Siciliano07.qxd 3/20/2003 11:23 AM Page 102
Finance for Non-Financial Managers
102
Since current liabilities
Current ratio A compar-
ison of current assets and
rent assets, having a ratio
current liabilities, a com- must be paid out of cur-
monly used measure of short-run sol- of 1:1 should be OK,
vency—the immediate ability of a right? Wrong. Now don’t
company to pay its current debts as feel too badly, because
they come due.The current ratio is that would seem logical on
particularly important to a prospec- the surface, but let’s look
tive lender or supplier that is consid-
at this for a moment.
ering extending credit.
Current liabilities are
bills with a firm due date
and the requirement to pay them in full—all of them. Current
assets probably consist of some accounts receivable and inven-
tory. Do you recall the discussion about these assets in Chapter
3? They don’t always deliver 100 cents on the dollar. Some-
times customers pay late and sometimes they don’t pay at all.
Sometimes inventory sells for full value and sometimes it
becomes worthless or simply disappears. So a company needs
more than $1 of current assets to cover each dollar of current
liabilities. Most banks want to see ratios of 2:1 or better to give
them adequate reassurance that the business will have the cash
needed when it’s time to write checks. This standard will vary
by industry, of course, because different industries have differ-
ent working capital risk characteristics.
Quick Ratio
This is a variation of the current ratio, but with a slight twist. It
removes inventory from the calculation on the assumption that
inventory returns to cash much more slowly, and with more
risk, than other current assets. Do you remember the bad things
that can happen to inventory while it’s sitting around waiting to
be sold? And that doesn’t count the added time and cost that
must be put into raw materials before they can become finished
goods and even begin to be sold. So removing inventory results
in a total for current assets that will more quickly become cash.
This becomes a more conservative version of the current ratio
and it’s calculated like this: