Question

Both ABC Corp and XYZ Corp have a current ratio of 2.6.

ABC Corp has a quick ratio of 1.6 while XYZ has a quick ratio of 2.2.

Compare and contrast the liquidity of these two companies.

Answer 1

The current ratio [current assets/current liabilities] of 2.6

indicates a comfortable short term liquidity position. It

means that the current assets are more than twice the

current liabiities and hence there won't be any difficulty in

meeting the current liabilities as they mature for payment.

However, the current ratio has a flaw in that, it considers all

current assets as equally liquid, which in fact is not true.

Cash, cash equivalents, marketable securities and

receivables are collectible without much delay as they can be

directly converted into cash. But, inventories, prepaid

expenses etc are not convertible into cash directly. Inventories

would be substantial and can be realized in cash only in due

course of operations. Hence, it cannot be considered as a

highly liquid current asset.

The acid test ratio computed as [Cash and cash equivelents+

marketable securities+receivables]/Current liabilities, is a

more stringent measure of liquidity as it excludes the most

illiquid of current assets, which is inventory.

When the quick ratio is taken into account, XYZ is more sound

in terms of short term liquidity, as its quick ratio is much higher

at 2.2.

A quick ratio of 1 or more is generally considered satisfactory

and hence the liquidity position of ABC is also good.