The overall objective of most businesses is to earn a satisfactory return on invested funds, consistent with maintaining a sound financial condition. There are at least two aspects of a sound financial condition:
(1) ability to meet current obligations (liquidity);
(2) ability to meet interest costs and repayment schedules associated with long-term obligations (solvency).
Liquidity ratios have to do with the size and relationships of current liabilities, which are the obligations soon coming due, and current assets, which presumably provide the source from which these obligations will be met. Fixed assets are usually harder to convert into cash.
It is important that a business have an adequate amount of current assets so that it can meet its current liabilities. For example, other considerations being equal, a company whose current assets are three times as large as its current liabilities would probably be more able to meet its current liabilities in an emergency than a business whose current assets are two times its current liabilities.
The first test of liquidity is the current ratio, which is obtained by dividing the total of the current assets by the total of the current liabilities. In the case of Quality Bed Linens Company the said ratio was 2.3 on December 31, 2008 and 2.4 on December 31, 2009.
There is a rule of thumb that the current ratio should be at least 2 to 1. However, this is a very rough rule, because the patterns of industries differ and because the current ratio does not indicate the quality of the assets composing it.
Assets that are easily converted into cash are sometimes called liquid assets. The current ratio is a test of the amount of liquid assets relative to the amount of current liabilities.
Some current assets are more liquid than others. Inventory, for example is less liquid than cash.
Bed Linens Company has a current ratio of 2.0. Canopy Tops Corporation has the same ratio of 2.0. Most of Canopy Tops Corporation’s current assets are cash and government bonds, while most of Bed Linens Company’s are in inventory. Which company has more liquid assets? Of course it is Canopy Tops Corporation.
Evidently, the current ratio test tells us about the relative amount of current assets, not their relative liquidity.
A company with a very large amount of current assets may not be making productive use of its resources. Such a company may have a high current ratio. Therefore, the aforesaid ratio that is very high is not necessarily good.