With the term “liquidity crisis” currently flying around like shit in a pigpen, now is a good time to discuss the quick ratio, which is a strong test of liquidity. As such, the quick ratio provides insight to the short term financial health of a company. I like the quick ratio because it is more conservative than Rush Limbaugh - the formula assumes inventories are worthless and subtracts their value from current assets. Thus, liquidity of firms that have a hard time unloading inventory* is not positively distorted like it can be with the current ratio, a similar performance measure.
To calculate the quick ratio, subtract inventories from current assets and then divide by current liabilities. In general, a quick ratio greater than 1.0 shows that a company is liquid. In practice, the railroads I am using as examples rarely have a quick ratio over one and acceptable quick ratios vary by industry. If the quick ratio falls significantly from year to year, it is a warning sign of potential future liquidity problems.
Calculating the quick ratio is easy, because all the inputs are found in one place - the consolidated balance sheets. Inventories are found on the balance sheet under assets. In the case of the railroads, inventories are often labeled as materials and supplies - since they do not manufacture anything they do not have traditional inventory like widgets, half built widgets and raw materials laying around. They do, however, need to keep fuel on hand along with oil and spare parts. Current liabilities are also found on the consolidated balance sheets and are labeled as such.
| Company | Quick Ratio | ||
|---|---|---|---|
| 2006 | 2005 | Average 2001-2005 | |
| BNSF | 0.50 | 0.50 | 0.40 |
| Canadian National | 0.50 | 0.50 | 0.60 |
| Canadian Pacific | 0.70 | 0.70 | 0.70 |
| CSX | 1.00 | 0.70 | 0.80 |
| Norfolk Southern | 1.10 | 1.30 | 0.80 |
| Union Pacific | 0.60 | 0.60 | 0.70 |
| Industry | 0.70 | 0.70 | 0.70 |
CSX and Norfolk Southern (NSC) currently have the highest liquidity of all the railroads, based on the quick ratio. BNSF (BNI), Canadian National (CNI), and Union Pacific (UNP) are all below the industry average. CNI and UNP both have quick ratios below their respective five year averages, as well.
Besides being inherently useful, the quick ratio is one component of Harry Domash’s Impending Bankruptcy Indicator, a very useful tool.
For further reading, see the next post in the series: Foolish Flow Ratio, the previous post in the series: Enterprise Value to Free Cash Flow, or the first post in the series: Railroad Performance Measures: Operating Ratio.
notes:
* Like homebuilders during the biggest housing downturn since the Great Depression.
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