Two Companies, One Ratio
You are comparing two firms in the same industry for a supplier-credit decision. Both report a current ratio of 1.6 and a quick ratio of 1.0.
Company A: current assets $80M (cash $30M, receivables $30M, inventory $20M), current liabilities $50M. Inventory turns 9× per year. Receivables are 85% from three investment-grade customers. The $50M current liabilities include $10M of long-term debt maturing next month that management intends to refinance.
Company B: current assets $80M (cash $8M, receivables $52M, inventory $20M), current liabilities $50M. Inventory turns 3× per year. Receivables include $25M from a single customer that is itself in restructuring. Average collection period is 95 days. Current liabilities are all trade payables and a $20M revolver that is fully drawn and due on demand.
1. Explain why identical current and quick ratios mask very different liquidity positions.
Read the worked answer
Ratios are aggregates; liquidity is about composition, timing, and quality.
- Cash weight: A holds $30M cash (37.5% of current assets) vs. B's $8M (10%). Cash is the only current asset that pays bills without conversion risk.
- Receivable quality: A's receivables are diversified and investment-grade (fast, reliable collection). B has 95-day collection and $25M - nearly half its receivables - from a customer in restructuring, which may be worth cents on the dollar. The quick ratio treats a doubtful receivable as equivalent to cash; it is not.
- Inventory velocity: A turns inventory 9× (≈40 days); B turns 3× (≈120 days). Slow inventory is closer to illiquid and at risk of obsolescence.
- Liability structure: A's $50M includes $10M long-term debt that will be refinanced - economically a long-term obligation, so the true current-liability burden is lower. B's liabilities are trade payables plus a demand revolver - the most fragile funding: the lender can call it, and trade payables must be paid or supply stops.
Same headline numbers, but A's current assets are closer to cash and its obligations are more patient. B's liquidity depends on converting questionable receivables and slow inventory before a callable revolver.
2. Which company would you extend trade credit to, and how would you adjust the analysis beyond the reported ratios?
Read the worked answer
Extend to A; decline or require security from B.
Adjustments (the ratios are misleading as reported):
- Reclassify A's refinanced debt: if refinancing is credible, remove $10M from current liabilities → adjusted current ratio ≈ 80/40 = 2.0, stronger than reported.
- Haircut B's receivables: apply a realistic recovery (say 30–50 cents) to the $25M distressed account → adjusted quick assets fall sharply, and the quick ratio drops well below 1.0.
- Treat B's demand revolver as immediately payable: it is callable, so it is effectively more current than a scheduled maturity.
- Inventory: discount B's slow-moving inventory for obsolescence risk.
Conclusion: On a quality-adjusted basis the two firms are far apart. A has genuine, near-cash liquidity and patient liabilities; B's liquidity is illusory - concentrated, slow, and backed by callable funding. For a supplier, B's inability to pay trade payables promptly (already reflected in a stretched profile) is the direct risk.