The very first thing that I do when evaluating a stock is to examine its balance sheet. The balance sheet tells you just how safe and sound a company is. Does it have a lot of debt? Does it have plenty of cash to weather a downturn in the economy?
Looking at just the numbers, however, makes meaningful evaluation difficult. Most large publicly traded companies have billions in assets and liabilities, which can make it difficult to draw any actionable conclusions. And that’s where the current ratio and quick ratio come in handy. These easy to calculate ratios can quickly tell you just how healthy a company’s balance sheet really is.
So in this article will look at how to calculate these ratios. Then I’ll show you some free online resources that calculate them for you. And finally, we’ll look at some benchmarks that will allow you to evaluate a company’s financial wherewithal based on these ratios.
How to Calculate these Ratios
While there are plenty of online resources that do the calculations for you (see the next section), it’s important to understand how the current and quick ratios work. As noted above, both ratios offer a quick and easy tool used to measure the financial liquidity of a company and its ability to pay short-term obligations.
Current Ratio = Current Assets / Current Liabilities
Current Assets are assets expected to be (or could be) converted to cash within a year. The most common Current Assets are cash, short term investments, inventory and accounts receivable. Note that inventory and accounts receivable are typical, though not always, reported as current assets because management expects the inventory to be sold and the A/R to be collected within a year.
Similarly, Current Liabilities are liabilities that are due within a year. The most common Current Liabilities are accounts payable, short term debt, current long-term debt, accrued expenses and income taxes payable. Current long-term debt is different than short-term debt in that the former is only the portion of the long term debt that is due within a year while the latter was always short term (such as a credit line).
To take an example, Apple has a current ratio of 1.50 as of its last annual filing (September 2012). The calculation is as follows:
$57 billin in current assets / $38 billion in current liabilities = 1.5
A current ratio of 1 or more is generally considered healthy, although this does vary by industry.
Not all Current Assets are created equal. While cash is king, inventory may or may not be sold and converted to cash within the next 12 months. Inventory can become obsolete or a company can have more inventory than it can sell (called excess inventory). While companies are required to estimate an O&E reserve, as it’s called, and deducted the reserve from its reported inventory, sometimes these estimates are off.
And that brings us to the quick ratio.
The quick ratio is similar to the current ratio, except that a company’s inventory is subtracted from current assets before making the calculation. It looks like this:
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Because inventory is subtracted from current assets, the Quick Ratio is always less than the Current Ratio.
Apple’s Quick Ratio for the period ending September 2012 was 1.24, calculated as follows:
($57 billion in current assets – $800 in inventory) / $38 billion in liabilities = 1.48
You’ll notice that Apple’s quick ratio is only slightly lower than its current ratio. The reason is that Apple has relatively little inventory. While that may be surprising for a company that sells consumer products, it’s a testament to Apple’s incredible supply chain efficiency.
There are many online tools that will give you the current and quick ratio for any public company. My favorite tool is Morningstar. With Morningstar, you can enter any ticker symbol and quickly get access to key ratios. To find the current and quick ratios, you click on the Key Ratios navigation item after entering a ticker, scroll down to the Key Ratios section, and click the link for Financial Health. For Apple, the Financial Health ratios look like the following (click image to enlarge):
One thing of note in the above image is that Morningstar reports Apple’s quick ratio as 1.24. I think that’s an error. It’s quick ratio is 1.48, as reflected by the NASDAQ (which reports the quick ratio as a percentage, 148%). And that underscores the importance of understanding how any ratio is calculated and not to take at face value what another website is reporting.
The Current and Quick Ratios in Action
So what is considered a healthy current and quick ratio? While the answer can vary from industry to industry, generally ratios of 1 or higher is considered healthy. A current ratio of 1 means that a company’s current assets equal its current liabilities. A ratio of more than 1 means the company has more current assets than current liabilities. Thus, with a ratio of 1 or higher, the company should have no problem covering its liabilities over the next 12 months.
As another example, below is the balance sheet for Tesla Motors (TSLA) from the most recent quarterly report.
Tesla appears healthy because the ratio is ~1, meaning it could basically pay off its short term obligations with its short term assets. A look at its quick ratio of just over .5, however, shows that a substantial portion of its current assets are tied up in inventory. That means that its ability to pay its current liabilities over the next 12 months will depend in part on its ability to move its inventory.
A minimum Current Ratio of 1 is usually a good sign although 1.5 or 2 is safer. However, if the ratio is below 1 a company can still operate if it generates strong cash flow or has access to financing such as selling bonds or a line a credit.
For manufacturing or industrial firms, a minimum Current Ratio of 1.5 is considered safe. For less capital intensive industries such as software, a lower ratio is acceptable. It is important to only compare companies within the same industry. For example, Adobe (ADBE) and Peabody Energy (BTU) should not be compared to each other because Adobe is a software company with low capital requirements while Peabody Energy is a coal company with high capital requirements. Adobe can operate with much less capital than Peabody Energy and can therefore have a lower Current Ratio.
It is also important to look at the trend of the Current Ratio. Is it going up, down or staying the same? Look for companies where the Current Ratio is either staying the same or slightly rising. If the ratio is falling, the company may have trouble meeting its obligations in the future.
Apple’s trend, for example, shows a falling current and quick ratio over the last decade, although the most current quarter reflected an uptick. In Apple’s case, however, a part of this trend is likely from its use of cash to pay dividends and buy back its own stock. For this reason, the trend doesn’t concern me.
Also, look at the trend of the composition of current assets. Are inventories and accounts receivable growing while cash is falling? Higher inventories could be a sign of reduced customer demand for products or it could mean the company ramped up production for a new product roll-out. If accounts receivable are rising it could mean the company is selling more products but customers are taking longer to pay. It’s important to see why certain numbers or ratios are changing.
A note of caution. If the current ratio is too high (above 3), it may mean there is an inefficient allocation of company resources. For example, if there is too much cash sitting on the balance sheet earning little interest (especially in the current zero interest rate environment), this may indicate the company does not have any good opportunities to invest the money.
In summary, the current and quick ratios are a simple to use tool to gauge the financial health of a company and a great starting point in your research.