Liquidity ratios in Excel - Microsoft Excel Tutorial

- [Instructor] Liquidity is a key variable that firms often focus on. It sometimes determine whether a company can actually stay in business or not. Given the critical nature of that analysis, we have a separate set of ratios that will let us judge liquidity for the firm. We have what we refer to as liquidity ratios. These essentially answer the question can the company meet its short-term obligations given the level of resources it has on hand right now? And there's two primary ratios that you wanna be aware of. The first is the current ratio. The second is the quick ratio. The current ratio is just current assets divided by current liabilities. In case you aren't familiar with the prefix current, here, what we're referring to is assets that are convertible into cash in less than one year or assets that are already in cash. Liabilities are liabilities or debts that will come due within the next year. So, liabilities perhaps for a bank or something like that that might be owed in six months' time. The quick ratio is just a small modification on the current ratio. The idea is that sometimes inventory on a company's balance sheet is not as salable as we'd actually like it to be. So, the quick ratio takes current assets minus inventory and then divides by current liabilities. Notice what each of these ratios does. By itself, neither current assets nor current liabilities is all that useful. They're simply related to the size of the company. Bigger companies have more assets. They also have more liabilities. The ratio of these two tells us whether this company is risky or not and the level of dollars they have on hand to pay dollars they owe to others. Now, let's turn to an example. I'm in the 04_02_Begin_Ratios Excel file. So, I'd like to compute for our fictional firm, here, the current ratio and the quick ratio as actually occurring at the end of 2017, and as projected at the end of 2018, and I've given you ranges for what's normal. A five or so for current ratio is a very normal and safe number. A range of three for quick ratio is relatively normal and safe. So, let's compute the ratio for 2017. Now, just as a reminder, I've included a comment in each of these ratio formulas. The current ratio, here, is equal to current assets divided by current liabilities. While my comment on the quick ratio is that the quick ratio is equal to current assets minus inventory divided by current liabilities. Now, to compute this current ratio, we'll simply come down here to our balance sheet, we'll find current assets, and then divide it by current liabilities. And we can drag and drop over, and what we observe is that liquidity is relatively weak for this firm. They don't have a lot of assets on hand to pay their liabilities. What this ratio of 1.72 indicates is that the firm has $1.72 on hand in current assets to pay every one dollar in current liabilities that it owes. That's not an overly safe firm. They may or may not run into liquidity trouble but it's not overly safe. How about the quick ratio? So, here, I'm gonna take our current assets and I'm going to subtract off inventories. Then we're going to divide by our current liabilities. And when we do that, we find that the quick ratio has fallen versus the current ratio, and the quick ratio, unsurprisingly, since we're removing inventory, is roughly .3 lower than in the case of the current ratio. So, our quick ratio, where a normal range might be around three or so is gonna be at 1.45 in reality for 2017 and 1.22 by the end of 2018. Clearly, the firm's financial position, from a liquidity standpoint, is weakening. This is a company that may face some liquidity challenges. By the end of 2018 under the projection shown here, they are only going to have $1.22 of liquid assets for every one dollar in liabilities that they will owe. Now that you've seen how to evaluate the current ratio and quick ratio in practice, and how to compute them, you are better positioned to play a role in evaluating your firm's own financial position.