In this article, we'll examine the "dynamic current ratio" to assess a company's liquidity status instead of the static but commonly used current ratio. It is often calculated alongside the quick ratio and the cash ratio, to provide analysts with a more complete picture of the short-term liquidity of the company being analyzed. Although these ratios have their flaws, the dynamic current ratio has several advantages compared to the quick and cash ratios. Read on to learn more about how you can use this ratio when analyzing a prospective investment.
TUTORIAL: Financial Ratios
Current Ratio = Current Assets / Current Liabilities
|Current Ratio=||Inventory + Accounts Receivable + Cash Equivalents + Cash
Accruals + Accounts Payable + Notes Payable
The drawback of the current ratio is that we do not know how liquid inventory and accounts receivable really are. This means that a company with a very large part of its current assets tied up as inventory could show a relatively high current ratio but still exhibit a rather low level of liquidity.
|Quick Ratio =||Accounts Receivable + Cash Equivalents + Cash
As we can see, the quick ratio does not contain any inventory. Accounts receivable are included but still without any indication as to how easily these receivables can be turned into cash. (Learn more about the quick ratio and others in our Liquidity Measurement Ratios Tutorial.)
|Cash Ratio =||Cash Equivalents + Cash
Because the cash ratio measures only the most liquid of all assets against current liabilities, it is seen as the most conservative of the three mentioned liquidity ratios. As it is generally accepted in the accounting literature to maintain a high degree of prudence in both the preparation and analysis of financial statements, the cash ratio may not be such a bad idea. However, it often lacks accuracy, which may limit its usefulness.
Although the cash ratio does not provide a true and fair picture of a company's short-term liquidity - no ratio does and no ratio, in isolation, will ever be able to do this. Nevertheless, the dynamic current ratio provides the analyst with a more accurate and complete way of assessing short-term liquidity than any of the aforementioned ratios.
Dynamic Current Ratio
One way of measuring the liquidity of inventory is to use the inventory turnover ratio to calculate the approximate number of times that inventory turns over per year. One could say that the more times inventory turns over, the more often you exchange inventory for cash and, as such, the more liquid it is. The same applies to accounts receivable when calculating the accounts receivable turnover ratio. That is, the more often accounts receivable turns over, the more often you exchange accounts receivable for cash and the more you extend its nearness to cash, i.e. its level of liquidity. Both ratios are shown below:
|Inventory turnover ratio =||COGS / Average Inventory
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
The opposite of an accounts receivable transaction is known as an accounts payable transaction. In other words, whatever is "paid" by the debtor is "cashed" by the creditor. Because a rising accounts receivable turnover ratio points to increasing liquidity, it becomes clear that a rising accounts payable turnover ratio can only indicate a decreasing liquidity. Therefore, the more often you pay your bills, the less money you can keep and the less liquid you will be. The accounts payable turnover ratio is shown below:
|Accounts payable turnover ratio =||COGS – (Beginning Inventory – Ending Inventory)
Average Accounts Payable
The dynamic current ratio is based on a combination of the current ratio and the three turnover ratios mentioned above, resulting in a liquidity ratio that takes into account the company's respective liquidity with regard to both inventory, accounts receivable and accounts payable. (To learn more about evaluating a company's finances, check out Diving In To Financial Liquidity.)
In today's world of credit sales, the minimum time a company has to settle its bills without adversely affecting its credit relationships is 30 days. This means that there are at least 12 "risk-free" credit cycles per year. The more management extends its credit cycle, the more it risks defaulting on its payments. Based on this, one can argue that an inventory turnover ratio of six, meaning that the inventory is exchanged for cash six times per year, represents a 50% liquidity, (six cycles/12 months = 0.5 = 50%). An inventory turnover ratio of two would mean that the inventory is 16.67% liquid (two cycles/12 months = 0.1667 = 16.67%), and so forth. Using the following table is a fast way to determine the level of liquidity for either inventory, accounts receivable or accounts payable for a company with 12 "risk-free" credit cycles per year:
Knowing the turnover ratios for inventory, accounts receivable and accounts payable, we can apply the above percentages to calculate the dynamic current ratio.
|Dynamic Current Ratio =||Inventory(ITR/12) + Accounts Receivable(ATR/12) + Cash Equivalent + Cash
Accruals + Accounts Payable(APT/12) + Notes Payable
ITR = Inventory turnover ratio
ATR = Accounts receivable turnover ratio
APT = Accounts payable turnover ratio
An Example of How to Use the Dynamic Current Ratio
Inventory = $100,000
Accounts receivable = $20,000
Cash equivalents = $10,000
Cash = $5,000
Accruals = $ 20,000
Accounts payable = $30,000
Notes payable = $10,000
Inventory turnover ratio = 5 = 41.67% liquidity
Accounts receivable turnover ratio = 4 = 33.34% liquidity
Accounts payable turnover ratio = 2 = 100% –16.67% = 83.34% liquidity
An accounts payable turnover ratio of three represents a 83.34% liquidity, because accounts payable are inserted in the denominator, and not the numerator as is the case with inventory and accounts receivable. The reading of 16.67% must be used in this example:
|Dynamic Current Ratio =||$100,000(0.4167) + $20,000(0.3334) + $10,000 + $5,000
$20,000 + $30,000(0.1667) + $10,000
|Dynamic Current Ratio =||$41,670 + $6,668 + $10,000 + $5,000
Had we instead used the current ratio (2.25) to do the same calculation, we would have overstated the company's short-term liquidity, and with the quick (0.58) and cash ratio (0.25) the company's liquidity would have been clearly understated.
The investor should be aware that management has to seek an optimum balance between the advantages of a high level of liquidity and the disadvantages of an excessively high accounts receivable turnover ratio. If the company has to offer large rebates in return for early payment and to employ a very aggressive credit department that places strain on management's relationships with its customers, credit terms may have to be reconsidered. The cost of lost customers is seldom measured, but this cost can far outweigh the gains made from higher short-term liquidity.
In turn, an excessively low accounts payable turnover ratio may lead to angry suppliers, and excessively high inventory turnover ratios may lead to supply shortages and angry customers. What might be right for one company may not be right for another. Credit policy terms and inventory turnover ratios should be compared to those in a company's industry and among its competitors.
In general, the dynamic current ratio represents an improvement over current liquidity ratios, but the investor should be aware that ratios are only as reliable as the data on which they are based. Consequently, ratios should not be used as the only tool or source of information when analyzing financial statements, but should be supplemented with other sources of information, such as vertical and horizontal analysis.