Liabilities: How to Judge Liquidity and Solvency of a Business
Solvency refers to the ability of a business to pay its liabilities on time. The liquidity of a business is not a well-defined term; it can take on different meanings. However, generally it refers to the ability of a business to keep its cash balance and its cash flows at adequate levels so that operations are not disrupted by cash shortfalls.
In extreme cases, a business can be thrown into involuntary bankruptcy. Even the threat of bankruptcy can cause serious disruptions in the normal operations of a business, and profit performance is bound to suffer.
If current liabilities become too high relative to current assets — which constitute the first line of defense for paying current liabilities — managers should move quickly to resolve the problem. A perceived shortage of current assets relative to current liabilities could ring alarm bells in the minds of the company’s creditors and owners.
Short-term, or current, assets include:
Marketable securities that can be immediately converted into cash
Assets converted into cash within one operating cycle, the main components being accounts receivable and inventory
The operating cycle refers to the repetitive process of putting cash into inventory, holding products in inventory until they are sold, selling products on credit (which generates accounts receivable), and collecting the receivables in cash.
In other words, the operating cycle is the “from cash — through inventory and accounts receivable — back to cash” sequence. The operating cycles of businesses vary from a few weeks to several months, depending on how long inventory is held before being sold and how long it takes to collect cash from sales made on credit.
Short-term, or current, liabilities include non-interest-bearing liabilities that arise from the operating (sales and expense) activities of the business. A typical business keeps many accounts for these liabilities — a separate account for each vendor, for instance. In an external balance sheet you usually find only three or four operating liabilities, and they are not labeled as noninterest- bearing.
In addition to operating liabilities, interest-bearing notes payable that have maturity dates one year or less from the balance sheet date are included in the current liabilities section. The current liabilities section may also include certain other liabilities that must be paid in the short run.
The sources of cash for paying current liabilities are the company’s current assets. That is, current assets are the first source of money to pay current liabilities when these liabilities come due. Remember that current assets consist of cash and assets that will be converted into cash in the short run. To size up current assets against total current liabilities, the current ratio is calculated.
Generally, businesses do not provide their current ratio on the face of their balance sheets or in the footnotes to their financial statements — they leave it to the reader to calculate this number. On the other hand, many businesses present a financial highlights section in their financial report, which often includes the current ratio.
The quick ratio is more restrictive. Only cash and assets that can be immediately converted into cash are included, which excludes accounts receivable, inventory, and prepaid expenses.
Folklore has it that a company’s current ratio should be at least 2.0 and its quick ratio 1.0. However, business managers know that acceptable ratios depend a great deal on general practices in the industry for short-term borrowing.
Some businesses do well with current ratios less than 2.0 and quick ratios less than 1.0, so take these benchmarks with a grain of salt. Lower ratios do not necessarily mean that the business won’t be able to pay its short-term (current) liabilities on time.