Now I will introduce a concept to gauge the liquidity of a business. It deals with the company’s ability to pay its creditors on time. Typically we want to see a company with Current assets greater than Current liabilities. This ensures that it can pay off all its short term obligations, else the creditors may impose liquidation of the business to get their dues back, which is not a very rosy scenario.
To check this, a common ratio that is used is called CURRENT RATIO calculated as below:
Current assets/Current liabilities
As you would have rightly guessed by now, a current ratio greater than 1 shows a decent liquidity position. If this ratio is greater than 2, it provides an even better safety buffer from liquidation perspective.
It is important though to view this ratio with respect to the industry or company’s business as well. Sometimes a company has a strong bargaining position over its suppliers and uses the credit from suppliers to finance its own operations. In that case the company can run a current ratio under 1.
Let’s take the example of Proctor & Gamble, the famous FMCG company. Looking at their current assets and current liabilities as of June 2017, we can see that the company is effectively financing its inventory and receivables using the credit from its suppliers:
(All numbers in USD mm)
Chapter 14: Long term debt and other liabilities
Chapter 12: Current liabilities
As discussed in the Balance Sheet basics, liabilities refer to the obligations of a business. Current liabilities are the obligations due within one year timeframe. Major items under current liabilities are as follows:
- Payables: This is when a business buys some goods or services on credit. Let’s say our hot dog business owner buys the ingredients from a grocery store with a promise to bill to pay within 30 days. In this case, hot dog owner will record this transaction as a Payable on the company’s balance sheet while the grocery store will record it in Accounts receivables.
- Accrued expenses: These are the expenses incurred by the business but not yet paid out. Typically staff salaries, marketing expenses, which are billed, say monthly/quarterly etc. come under this category.
- Short term debt/loan: This is the loan taken by the company to meet its short term cash requirements, i.e. to buy the inventory for production of goods. As the inventory is sold, the company pays back the loan and repeats the cycle. Other uses of this cash could be payment of bills or anything which is required to keep the business running.
- Long term debt due in 12 months: As the name suggests, the company borrowed money for a tenor greater than 1 year at some point in past, but as of the reporting date the company has to pay it back within 12 months.
For the short term debt, I would also check whether it is used to finance long term assets. If it is doing so, that is red flag as it can potentially pose problems when the liquidity dries up in the market, in other words, when the banks stop lending due to worsening business conditions or other factors. It can also negatively impact the P&L if the interest rates are going up – more the interest rates for rolling over the debt, lesser is the profit left for the business owners.
Other current liabilities, if any, would ideally not be significant enough to worry about.
Chapter 13: Current ratio
Chapter 11: Non-current assets