Short Term Debt Repayment: What Ratios to Focus On to Stay Solvent

We've already covered how to analyze the effectiveness and efficiency of a business, which when combined, will help us evaluate the overall return on investment of a company. However, knowing ROI of a company is not enough. Even though we want to make money from our investment into a company, we definitely don't want to lose money. 

And the prerequisite of not losing money is that the company must sustain its business operations, i.e. it must have the ability to pay back its debt.

In this episode, let's look at how to evaluate a company's ability to deal with liabilities.

If you recall on balance sheet, all liabilities are divided into two parts: current liabilities and non-current liabilities. Current liabilities refer to those debts to be repaid within one year, and non-current liabilities refer to those longer than one year. 

In a similar fashion, we will also categorize the ability to pay back debts into current (or short term) and non-current (or long term). Let’s first look at the ability to pay back short term debt.

Short term debt repayment capacity

The capacity to repay short term debt measures a company's ability to deal with current liabilities. 

What do current liabilities consist of?

For instance,we may need to pay suppliers money, or accounts payable. If we want to pay suppliers, what is the most appropriate source of money, other than cash?

We won't be able to apply for a new loan from the bank to pay the suppliers, as it will take too much time. 

If I tell the supplier that I will invest in a project and pay him after the project earns money, he definitely won’t wait.

So where should the payment come from?

If I have cash in hand, that would be perfect. But if I don’t have cash, what I can do is to look at assets that can be easily converted into cash. For example, I can sell products in inventory and collect accounts receivables, both of which are current assets. In fact, for paying suppliers, the most common cash flow comes from current assets.

Let’s make the most optimistic assumption. Let’s assume that all current assets can turn into cash instantly. The amount of potential cash I can use will be the total of all current assets. By dividing current assets by current liabilities, we can get a measure called current ratio to help us evaluate a company's short-term debt repayment capacity. The higher the ratio, the stronger its ability to repay current liabilities.

Yet this calculation method is based on a very optimistic assumption, i.e. all current assets can turn into cash instantaneously. In reality though, this is impossible. So we need a more conservative and realistic method.

Amongst all current assets, the slowest asset that can be turned into cash is inventory. The reason is that we will need to first sell inventory and acquire accounts receivables, which will become cash upon collection. If we use the most conservative estimation that NO inventory will become cash at all, we should deduct all inventory from current assets before dividing it with current liabilities. The result is a more conservative estimation of a company's capacity to repay short-term debt called quick ratio.

Let’s work on an example of current ratio and quick ratio of our fictional company. 

The company's current assets are 40.7 million dollars, and its current liabilities are 63 million dollars. By dividing the former by the latter, we will get the current ratio of 0.65. 

The quick ratio should be calculated after deducting inventory from current assets. Since the company's inventory is 5 million, the result will be 35.7 million after the deduction, making the quick ratio at 0.57.

Making sense of current ratio and quick ratio

Now that we've already understood how to calculate current ratio and quick ratio, how do we make sense of them, i.e. what kind of current ratio and quick ratio would be acceptable, safe, and desirable for a company?

If the current ratio of a company is 1, would that company be in danger of insolvency? How is its capability to pay back short term liabilities?

We've already mentioned that the current ratio is based on the most optimistic assumption that all current assets can be converted into cash instantaneously. However, that's simply not the case in reality. If, for example, we are desperate to sell our products in order to repay debt, we will almost definitely need to apply a discount. Besides, some account receivables may never be collected. Therefore, if the current ratio is 1, we may actually be in danger. 

Despite all the above issues, there could be another problem if the current ratio is 1: even if all current assets become cash instantly to cover all current liabilities, there won't be any cash or inventory left for future operations. The company will still need to file for bankruptcy. 

Current assets have two roles in a company's operations. One is to cover current liabilities repayment, and the other is to provide fund for daily operations. 

It seems that a current ratio of 1 is not enough. But what about 2? 

If you've encountered certain accounting books, some of them might have mentioned that a current ratio of 2 would be ideal. It certainly sounds legit: since the roles of current assets are to repay current debts and sustain daily operations, having twice the amount of current liabilities as current assets certainly sounds safe.

But is it the case? Let’s look at a graph. 

In this graph, the y-axis represents current ratio, and the x-axis represents number of years before bankruptcy. The line at the top of the graph represents healthy companies, while the line at the bottom represents bankrupt companies. From this graph, we can see that the current ratios of healthy companies are always higher than those of bankrupt companies, regardless of which year. 

In addition, the average of bankrupt companies is actually around 2, even for the year before their actual bankruptcy! This directly contradicts what books have told us. So if you believe in this number and operate your company accordingly, you may make lots of mistakes and put your company on the line.

Then can we conclude that having a current ratio of 3 or 4 would be ideal? 

Well if you are operating a business in the United States, that would certainly be the case, as this graph is based on data within the country. However, if you are operating in other countries such as China, you might be too conservative. Let me tell you why.

In China , even current ratios of most healthy companies are between 1 and 2, lower than those of bankrupt companies in the US. This is because banks in China don't grant long-term loans, but they extend short-term loans multiple times, which are essentially the same as long-term loans. In other words, the source of funds to pay off current liabilities is not current assets, but new current liabilities. Under such a model, companies won’t face serious problems even with relatively low current ratios.