The Franchise Owner's most trusted news source


Log In / Register | Sep 24, 2017

Current Ratio and Quick Ratio

RALEIGH, N.C. – The current and quick ratio is an important benchmark for small business and franchise owners. Calculating it and comparing it to others in the same industry provides important insights into a business' solvency.

The current ratio assesses the ability of a company to meet its short-term obligations with the assets it has in hand that can quickly be turned into cash versus its current liabilities or obligations due in the next year. Current assets include cash, accounts receivable (what is owed the company for products or services purchased) and inventory. Current liabilities include debts that must be repaid within a year and accounts payable (or what the company owes to others). In general, a current ratio should exceed one, which means current assets match current liabilities.

And then there is the conservative quick ratio that shows more liquidity on whether a firm can pay its bills.

Quick ratio = Cash and equivalents + marketable securities + accounts receivables
                      current liabilities

Financial analyst Jenna Weaver cautions that one must know the industry. All current or quick ratios are not the same. For example, a company that keeps a lot of inventory on hand may have the same current ratio as one that has a lot in accounts receivables on hand. But when the going gets tough, the company with accounts receivables wins because it is easier to receive cash from receivables than sell inventory at clearance sale prices.

"Current ratio is one measure of a company's ability to stay solvent in the short term, but it's not everything," Weaver said. "It doesn't give the whole picture of a company's cash flow."




Industries with high current ratios as of 12 months ended Aug 31, 2014

NAIC

Industry

Current ratio

8122

Death care service

4.9

4451

Grocery store

4.8

5313

Real estate activities

4.6

4481

Clothing stores

4.5

4471

Gasoline stations

4.3

8123

Drycleaning and laundry services

4

5613

Employment services

3.9

4461

Health and personal care stores

3.8

Source: Sageworks

As an example, Weaver points out that Wal-Mart has a current ratio of only 0.9, which does not reach the benchmark of 1. "They have such a great ability to turn their inventories and collect their receivables quickly that it's not as imperative for them to have a current ratio above one," Weaver says about Wal-Mart's rare hyper-efficiency. The retailing giant generated $23.3 billion in cash flow from operations in the fiscal year ended Jan. 31, 2014.

Weaver thinks that small business owners rarely check the current or quick ratio of major customers or vendors. By a nearly 2-1 margin, accounting professionals say that their business clients do not check enough to ensure the creditworthiness of customers.

One should be able to compare a convenience store franchise's quick ratio to other convenience stores. A ratio that is too low indicates a problem of solvency. A ratio that is too high could call into question the business's efficiency, since cash in the bank generally yields a lower return than does investments in new equipment, products or markets, says analyst Sageworks.

Why is the monitoring of quick ratios important? A franchisor with a poor current ratio could go belly up. That would cause the suppliers of the franchises to go scurrying off and customers to stay away from a franchised store as consumers learned of the franchisor's bankruptcy.

How does a small business owner obtain current ratio information from privately-held companies? Sadly, not all franchisors compile quarterly financial statements for franchisees. Not all vendors are publicly-traded companies with those financial numbers easily available. Sageworks suggests that the small business owner request that information as part of the vendor agreement. They also suggest using an accountant.

"That's why a small business owner should use their accountants as business advisory professionals versus just as tax professionals," writes Sageworks' spokesperson Melinda Crump to Blue MauMau. The accountant should benchmark the clients' vendor ratios against peers to make sure that the vendor is operating within the norms of industry peers. "If not, that could be another potential red flag that would require further investigation before signing into a relationship that may prove costly to the small business owner down the road," says Weaver.

A franchise owner has another resource. They can look at their franchisor's most recent Franchise Disclosure Document to see the prior year's financial statements of their franchisor. The Franchise Disclosure Document is a statement by the franchisor that is provided to franchisee candidates. Franchisors tend to file their disclosure documents for the previous year in March and April. Where can a small business owner obtain one? Firstly, these documents originate from the franchisor. There are also firms like WorldFranchising.com and FranchiseGrade.com that provide these documents for a fee. And certain states like California or Wisconsin have free franchise registrations online.

The table above shows industries with the highest current ratios, that is to say with the highest liquidity, according to a survey of financial statements by Sageworks. Each of these categories has franchisors and franchised outlets – from clothing store Gymboree, grocery store Save-A-Lot to dry cleaner Chem-Dry.

No votes yet

About Don Sniegowski

Don Sniegowski's picture

Public Profile

Don Sniegowski is editor of Blue MauMau, the daily news journal for franchise & small business owners. Call him at +1 (270) 321-1268, tweet @bluemaumau or email don@bluemaumau.org.