Accounting: The Language of Business - Vol. 2 (Intermediate: Part 85)

You have various institutions like law firms and accounting firms which bill by the hour. I'm really against that. You have an incentive to go slowly, be there as long as possible, to over-research things and over-staff.

Robert Pozen

Statements of Financial Position and Cash Flows and the Annual Report (Part V)

by

Charles Lamson

Liquidity and Solvency Analysis

The importance and usefulness of ratio analysis was covered in this blog back on Tuesday, September 29, 2020 in the post entitled "Foundations of Financial Management: An Analysis (part 8)." We now continue the discussion with a focus on the key balance sheet ratios of liquidity, covered in this post, and solvency, which will be covered in Part 86. Then, in Part 87, we will  link these concepts through DuPont Analysis.

Liquidity

Recall from Part 64 that liquidity measures a company's ability to meet current obligations from short-term resources. Specifically, it measures how quickly a company can convert assets into cash with minimal risk of loss in order to meet its current obligations. Generally, the more liquid a company's assets, the more likely it is that the company can meet its current obligations as they come due. There are two key measures of liquidity:

1. Working Capital

2. Current Ratio

 

Working Capital

Working capital is equal to current assets minus current liabilities.

Working Capital = Current Assets - Current Liabilities          (6B.1) 

When current assets are higher than current liabilities, this indicates that a company has sufficient current resources to meet its current obligations as they come due. Working capital is expressed in dollars and can vary with company size or growth. For example, the working capital of a large company will likely be higher than that of a small company simply due to the size difference. Therefore, it is important to be able to express working capital in a ratio.

Current Ratio

In contrast to working capital, the current ratio, also known as the working capital ratio, expresses liquidity as the ratio of current assets to current liabilities:

Current Ratio = Current Assets / Current Liabilities           (6B.2)

The numerator represents cash and the other current assets the firm expects to convert into cash within one year or operating cycle, whichever is longer. These resources are available to liquidate the short-term obligations due during the same period as the denominator. The current ratio indicates the proportion of current assets to each dollar of current liabilities. A current ratio higher than 1 typically means a company has sufficient current resources to meet its current obligations as they come due.

In practice, too much working capital or too high a current ratio can indicate that a company is forgoing profitable investment opportunities. A complete interpretation of the current ratio requires knowledge of trends and the industry in which the firm operates.

EXAMPLE 6B.1 Liquidity Analysis of Johnson & Johnson Company and Pfizer

PROBLEM: Using information from the 2016 balance sheets of Johnson & Johnson and Pfizer, answer the following questions about each company's liquidity.

1. Compute each company's working capital.

2. Compute each company's current ratio.

3. Based on equal assets, which company is larger?

4. Comments on what the working capital and current ratio indicate about each company. Comment on the size of the companies in the comparison.

SOLUTION: (A) and (B). The table below computes the working capital and current ratio for each company. 

C. Based on total assets, Pfizer is the larger company, with about 1.22 ($171,615 /141,208) times the total assets of Johnson & Johnson.

D. Both Johnson & Johnson and Pfizer have positive working capital and a current ratio more than 1. These measures indicate both companies are in a strong liquidity position. Johnson & Johnson's working capital is higher than Pfizer's. Because Pfizer is the larger company, it is surprising that its working capital is not higher. However, Johnson & Johnson's current ratio (2.47) is almost double that of Pfizer's (1.25). 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 308-309*

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