Computerized Investing > Fourth Quarter 2011

# Liquidity Ratio Analysis

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Liquidity ratios are used to determine a company’s ability to meet its short-term debt obligations. Investors often take a close look at liquidity ratios when performing fundamental analysis on a firm. Since a company that is consistently having trouble meeting its short-term debt is at a higher risk of bankruptcy, liquidity ratios are a good measure of whether a company will be able to comfortably continue as a going concern.

Any type of ratio analysis should be looked at within the correct context. For instance, investors should always look at a company’s ratios against those of its competitors, its sector and its industry and over a period of several years. In this issue’s Fundamental Focus, we investigate liquidity ratios using time-series analysis, competitive analysis and sector and industry analysis.

As an example of how to properly examine liquidity ratios, we will use the financial statement data for J. Alexander’s Corp. (JAX) found in AAII’s fundamental research database, Stock Investor Pro. While you can access financial statements directly on company websites, J. Alexander’s only offers two years of balance sheets at its site. For our purpose of examining trends in liquidity ratios, we need several years of financial statements in order to gather all the data. And since Stock Investor Pro contains yearly balance sheet figures going back seven years, our task is made much easier if we use the data offered there rather than downloading several years of reports from another source.

You may also find financial statement data at websites such as Yahoo! Finance and SmartMoney.com. Table 1 provides all the revelvant data for calculating these ratios.

### Current Ratio

The current ratio is the first of three financial ratios that we will examine. The formula for the current ratio is as follows:

Current Ratio = Current Assets ÷ Current Liabilities

As stated earlier, liquidity ratios measure a company’s ability to pay off its short-term debt using assets that can be easily liquidated. In this case, the current ratio measures a company’s current assets against its current liabilities. Generally, higher numbers are better, implying that the firm has a higher amount of current assets when compared to current liabilities and should easily be able to pay off its short-term debt.

As shown in Table 1, the company’s 2010 current assets are \$13,900,000 and its 2010 current liabilities are \$13,100,000. Plugging these numbers into our formula gives us a current ratio of 1.061 (rounded to 1.1).

 2010 2009 2008 2007 2006 Cash & equivalents (\$ thous) \$8,600 \$5,600 \$2,500 \$11,300 \$14,700 Accounts receivable (\$ thous) \$2,700 \$3,400 \$3,900 \$3,400 \$2,300 Short-term investments (\$ thous) \$0 \$0 \$0 \$0 \$0 Inventories (\$ thous) \$1,300 \$1,300 \$1,400 \$1,300 \$1,300 Other current assets (\$ thous) \$1,300 \$1,500 \$2,700 \$2,500 \$2,300 Total current assets (\$ thous) \$13,900 \$11,800 \$10,500 \$18,500 \$20,600 Total current liabilities (\$ thous) \$13,100 \$15,200 \$13,000 \$14,100 \$13,700 Source: AAII’s Stock Investor Pro, Thomson Reuters.

### Quick Ratio

The quick ratio, also known as the acid-test ratio, is a liquidity ratio that is more refined and more stringent than the current ratio. Instead of using current assets in the numerator, the quick ratio uses a figure that focuses on the most liquid assets. The main asset left out is inventory, which can be hard to liquidate at market value in a timely fashion. The quick ratio is more conservative than the current ratio and focuses on cash, short-term investments and accounts receivable. The formula is as follows:

Quick Ratio = (Cash & Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities

Once again, taking a look at the 2010 financial statements for J. Alexander’s, we find that cash and equivalents are \$8,600,000, accounts receivable are \$2,700,000 and short-term investments are \$0. Current liabilities are \$13,100,000 for the year. Plugging these figures into our formula gives us a quick ratio of 0.863, rounded to 0.9, for fiscal-2010.

### Cash Ratio

The cash ratio is the most conservative of the three liquidity ratios covered in this article. As the name implies, this ratio is simply the ratio of cash and equivalents compared to current liabilities. This ratio looks only at assets that can be most easily used to pay off short-term debt, and it disregards receivables and short-term investments. The argument for using the cash ratio is that receivables and short-term investments often cannot be liquidated in a timely manner. Receivables can be sold, or monetized, but the firm will not be able to get the full value of the receivables sold. Keep in mind that, due to their high liquidity, short-term Treasuries are considered cash equivalents, not short-term investments. The formula for the cash ratio is as follows:

Cash Ratio = Cash & Equivalents ÷ Current Liabilities

For fiscal-2010, the calculation for cash ratio involves using \$8,600,000 for the numerator of the equation and \$13,100,000 for the denominator. After plugging in the numbers, we find that the cash ratio for fiscal-2010 is 0.656, rounded to 0.7.

### Interpreting the Ratios

Calculating the ratios is typically the easy part. The difficulties lie in analyzing the ratios, interpreting their meaning and making an educated investment based on the findings. As with any fundamental ratio analysis, performing a time-series analysis, a competitive analysis and industry and sector analyses are good first steps.

 J. Alexander’s Corp. (JAX) 2010 2009 2008 2007 2006 Current ratio (X) 1.1 0.8 0.8 1.3 1.5 Quick ratio (X) 1.0 0.7 0.7 1.2 1.4 Cash ratio (X) 0.7 0.4 0.2 0.8 1.1 McCormick & Schmick’s Seafood Restaurant (MSSR) 2010 2009 2008 2007 2006 Current ratio (X) 0.5 0.6 0.6 0.7 0.8 Quick ratio (X) 0.4 0.5 0.5 0.6 0.6 Cash ratio (X) 0.1 0.2 0.1 0.1 0.3 Source: AAII’s Stock Investor Pro, Thomson Reuters.

In Table 2, the liquidity ratios for 2006 through 2010 are listed for J. Alexander’s and one of its main competitors, McCormick & Schmick’s Seafood Restaurants (MSSR). Note that the quick ratio we calculated for J. Alexander’s for 2010 is slightly different than the one shown in Table 2. Instead of short-term investments, Stock Investor Pro uses marketable securities in the numerator of the equation, causing its quick ratio calculation to be slightly higher. Either formula works as long as you remain consist in your analysis. For our analysis here, we use the figures provided by Stock Investor Pro.

As we stated, firms with higher liquidity ratios are better able to meet their short-term obligations. From Table 2, you can see that J. Alexander’s has significantly higher liquidity ratios across the board compared to McCormick & Schmick’s. For fiscal-2010, McCormick & Schmick’s has a cash ratio of just 0.1, meaning that it only has enough cash on hand to cover 10% of its short-term obligations.

Another major observation can be made using time-series analysis. Ratios for both firms were the strongest at the end of 2006, bottomed out in late 2008, and rebounded in 2009 through the end of 2010. This can be easily explained by the recession we experienced in 2008. J. Alexander’s and McCormick & Schmick’s are both high-end American restaurant chains known for their steaks and seafood. The firms are classified as consumer cyclical, meaning they will follow the market cycle. As our economy fell into recession, it was natural that fewer people dined at high-end restaurants. The two firms have less cash coming in and will possibly have to borrow more in order to weather the downturn. Both of these scenarios will place an added burden on liquidity ratios. Unsurprisingly, as the economy recovered, so did the liquidity ratios.

 Current Ratio (X) 2010 2009 2008 2007 2006 J. Alexander’s (JAX) 1.1 0.8 0.8 1.3 1.5 Sector (services) 1.2 1.2 1.3 1.3 1.4 Industry (restaurants) 0.8 0.8 0.8 0.8 0.8 Quick Ratio (X) 2010 2009 2008 2007 2006 J. Alexander’s (JAX) 1.0 0.7 0.7 1.2 1.4 Sector (services) 1.0 1.0 1.0 1.0 1.0 Industry (restaurants) 0.7 0.7 0.6 0.7 0.6 Source: AAII’s Stock Investor Pro, Thomson Reuters.

Finally, we perform an industry and sector analysis. J. Alexander’s is in the services sector and the restaurants industry. Table 3 compares the current and quick ratios for J. Alexander’s to its sector and industry medians. As you can see, both the company’s current and quick ratios dipped significantly below the sector medians during the economic recession. Once again, this should come as no surprise. While it is to be expected that the services sector may experience slight difficulties during tough economic times, it makes sense that high-end restaurants are especially affected. The same can be said for the restaurant industry. The industry as a whole may not suffer the declines that high-end restaurants experience. Consumers may opt for fast food or low-cost diners rather than steak and seafood. Overall, J. Alexander’s liquidity figures are rebounding back toward the sector medians and have always been strong compared to the industry.

### Conclusion

Liquidity ratios are just a small part of fundamental analysis. Looking only at these ratios would lead you to believe that J. Alexander’s is the stronger firm. Furthermore, the ratios imply that the best time to invest would have been sometime in early 2009.

However, there is often another side to the story. McCormick & Schmick’s is a larger firm with more locations. Weaker liquidity ratios may be due to aggressive expansion policies. As always, it is prudent not to rely too heavily on a single set of ratios, but to research the firm as a whole.

## Discussion

R Walker from AL posted over 5 years ago:

This is a good article.

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