In: Root » Legal and finance » Market and Finances » Keep its ratios of assets to liabilities above one
Current and Quick RatiosThe goal for any company is to keep its ratios of assets to liabilities above one, or, in other words, to have more assets than liabilities such that there are no restrictions in normal business activities due to a shortage of cash and no embarrassment of having to put off creditors. These proportions are often expressed as the current ratio or the quick, or liquidity, ratio. Lenders like to see more assets than liabilities because that means that the organization can find a way to repay its loans. To derive the current ratio, current assets are divided by current liabilities. The quick (or liquidity) ratio is an even harsher test of whether a company can pay back its loans. This ratio excludes inventory from the total amount of current assets and then divides by current liabilities. Inventory can sometimes be very difficult to sell. An example of hard-to-sell inventory is trendy fashions that suddenly go out of style. Was ABC MediCompany in a good position to have taken on the additional long-term debt to renovate, improve processes, and expand some of its marketing efforts? Even with the new debt, ABC has enough assets to pay its obligations. To see how this works out, let’s look at some financial ratios. Ratios are important to understand because they offer a shortcut to knowing what your Senior executives will value. Sometimes your executives will align management incentives and performance programs to improve a specific ratio. If you understand which two items are being measured against each other, you will know where to direct your WLP interventions and how to connect the value of what you bring to the table directly to the items in the ratio. Knowing a company’s current and quick ratios is only half of the story. Knowing what is reasonable and customary within a company’s industry is the other half. Let’s get a little more specific about the industry ABC MediCompany operates in. If you were to go to www.bizminer.com, select “Health Care,” and ask for a financial analysis profile for electromedical equipment, you would be able to find an industry financial analysis report that summarizes how other firms in this industry are doing. These profiles are not free, so keep in mind that there are other ways to find this information. This example just gives you a brief idea of what kinds of data you can find about an industry from existing financial data services. In the year ending July 2002 for the electromedical equipment industry, the average company maintained a current ratio of slightly over three (3.2) and a quick ratio of just over one and a half (1.6). Comparatively speaking, ABC is doing as well or better than its competitors. Because ABC seems to be in relatively good shape in its current ratio and quick ratio, would Senior executives pay as much attention to a proposal for how WLP could improve the ratio even more? If ABC were considering taking on even more debt the answer might be yes. If ABC were not considering more debt, then Senior executives may pay attention to other ratios first. Senior executives might rather want to know if they are getting enough value from the assets they already have. This leads to another ratio, return-on-assets (ROA).
Even though it is doing well compared to its industry, ABC appears to have reached the limit of the debt it can hold without being considered high risk. ABC will now have to look at ways to cut costs, raise revenues, or generally make better use of its assets to fund any additional investments it would like to make in its business. As a WLP practitioner at ABC, it would be important for you to target your interventions over the next one to three years to improve the leverage ratio to keep your organization out of the high-risk category. |
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