Accounting: The Language of Business (Part 72)

Do what you want as long as its paying off for you. But once its become a liability, then something is wrong and you better find out what it is.

Anton Szandor LaVey

Current Liabilities (Part G)

by

Charles Lamson

Financial Analysis and Interpretation

Current liabilities are listed on the balance sheet usually on the basis of size and maturity date of the liability. Current maturities of long-term debt followed by accounts payable are frequently the first two listed items. The current assets and current liabilities sections of the balance sheet for Noble Co. And Hart Co. Are illustrated as follows:

We can use this information to evaluate Noble's and Hart's ability to pay their current liabilities within a short period of time, using the quick ratio or acid-test ratio. The quick ratio is computed as follows:

Quick Ratio = Quick Assets / Current Liabilities

The quick ratio measures the "instant" debt-paying ability of a company, using quick assets. Quick assets are cash, cash equivalents (Examples of cash equivalents include commercial paper, Treasury bills, and short-term government bonds with a maturity date of three months or less. Marketable securities and money market holdings are considered cash equivalents because they are liquid and not subject to material fluctuations in value.), and receivables that can quickly be converted into cash. It is often considered desirable to have a quick ratio exceeding 1.0. A ratio less than 1 would indicate that current liabilities cannot be covered by cash and "near cash" assets. To illustrate, the quick ratios for both companies would be,

Noble Co: $100,000 + $47,000 + $84,000 / $220,000 = 1.05

Hart Co: $55,000 + $65,000 + $472,000 / $740,000 = 0.80

As you can see, Noble Co. has quick assets In excess of current liabilities, or a quick ratio of 1.05. The ratio exceeds 1, indicating that the quick assets should be sufficient to meet current liabilities. Hart Co., however, has a quick ratio of 0.8. Its quick assets will not be sufficient to cover the current liabilities. Hart could solve this problem by working with a bank to convert its short-term debt of $148,000 into a long-term obligation. This would remove the notes payable from current liabilities. If Hart did this, then its quick ratio would improve to 1 ($592,000 / $592,000), which would be just sufficient for quick assets to cover current liabilities. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 455-456*

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