Earlier on, we reviewed the Current Assets and Liabilities section of the Balance Sheet in detail.
Current Assets are generally cash or assets that the company should be able to convert into cash within the period of one year.
Similarly, Current Liabilities are obligations or commitments that must be settled by the company within a year.
As Current Assets and Current Liabilities are assets and liabilities, receivable or due within a period of one year respectively, it is appropriate to compare these two amounts as an indicator of the company’s liquidity.
The current ratio (as computed above), compares the current assets of a company against its’ liabilities. Generally, the higher the ratio, the more liquid the company is. If the current ratio is equal to 2.0x or more, the company is considered generally liquid, i.e. it should not have problems in meeting its’ short term obligations. If this ratio is less than 1.0x, then the company may have troubles to meet its' short term commitments. However, these are mere guidelines. The ratio may vary from industry to industry and care must be taken when interpreting this ratio.
Even when the current ratio is 2.0x or higher, it is important to analyze the components of the current assets. If the trade receivables or inventories are abnormally large, compared to previous years, then the DSO or Inventory Turn ratios' may raise alarms concerning the recoverability of the trade receivables or possibility of overstocking, respectively. If this is the case, although the current ratio is favorable, the company may still face liquidity issues due to problems in collecting debts or selling its’ inventories.
Generally, current assets indicate cash balances and those assets that are easily convertible to cash within a span of one year. If one wishes to be conservative, it may be better to exclude inventories from the current assets. This is because inventories may not be easily saleable, especially during a difficult economic climate.
The quick ratio compares HIGHLY LIQUID CURRENT ASSETS (i.e. Current Assets excluding Inventories) to the current liabilities. By and large, a ratio of 1.0x or higher, signifies that the company has good liquidity. This is because it can convert its’ HIGHLY LIQUID CURRENT ASSETS into cash to meet its’ short term commitments and obligations. Conversely, a quick ratio of less than 1.0x, indicates that the company may have issues in fulfilling its’ short term obligations. Take note that the figures are merely for guidance and may vary from industry to industry. Exercise care when interpreting the quick and current ratios.
Even if the quick ratio is 1.0x or higher, liquidity problems could still arise. If the company is facing troubles collecting amounts due from its customers, it will be reflected in large trade receivables balance and DSO ratio. In such a case, a quick ratio of 1.0x or more, may be meaningless as the company is unable to convert its’ trade receivables into cash to pay its’ short term commitments.
An analysis of Nestlé’s Current Ratio indicates it is hovering around 1.08x (2006: 1.20X). This lower current ratio is mainly due to the large amounts of loans and borrowings due within one year from the Balance Sheet date of 31 December 2007. This signifies that if Nestlé can convert all these current assets to cash, it would be able to repay all its’ commitments. Generally this is acceptable, especially considering that the banks would have no problems in refinancing these loans and borrowings due to Nestlé’s strong operating cash flows.
The Quick Ratio of 0.57x (2006:0.71x) implies that most of the company’s current assets are inventories. However, as Nestlé’s is in the Fast Moving Consumer Goods (FMCG) industry, it should have little problems in selling its’ inventories and converting these into cash. The lower ratio is not worrying as an analysis of the DSO and Inventory Turn ratio suggests that trade receivables are still being collecting promptly and there is only a moderate decrease in the turnover of inventories. Overall, operating cash flows are still significantly large to enable Nestlé to meet its’ short term commitments.
The Current and Quick Ratios' are convenient ratios to gauge the liquidity of a company. However, always keep in mind that a Current Ratio and Quick Ratio value of 2.0x and 1.0x respectively, does not necessarily mean the company is liquid. Further analysis of the DSO and Inventory Turn Ratio is required. This is to ensure that the favorable Current and Quick Ratios' are not due to mounting Trade Receivables and Inventories, arising from debt collection problems or non-saleable stocks.