The Acid Test
Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
One of the first lessons I learned about business was the need for assets to always be larger than liabilities. More importantly, current assets must be larger than current liabilities.
In the constant quest for a decent investment, one of the key questions is this: can the company cover its liabilities from its assets? Or is it effectively insolvent? Unfortunately this can become a minefield, as many companies can and will bulk up balance sheets with assets that could not be liquidated fast enough to cover liabilities, if they were called in.
The best way of getting through this mine field is to look into the current assets and liabilities on a company’s balance sheet. Current Assets/Liabilities are defined as being of use within the next 12 months. Effectively this is a test of whether or not a company will be able to cover liabilities falling due within the next year.
There are two ways of doing this:
1.Current Ratio = (Current Assets/Current Liabilities)
Can current assets cover current liabilities? If not, the firm is relying on longer term assets to bulk up its balance sheet and cover short term liabilities. In this case, liquidity of the long term assets can become an issue.
2. Acid Test/Quick Ratio = (Current Assets - Inventories) / Current Liabilities
This is the more telling of the two ratios. This ratio removes the current inventories from the balance sheet. Inventories are an asset that can become illiquid, as a buyer needs to be found at the right price, before they can be converted into cash. The Acid Ratio is designed to show if the firm has enough cash and short term investments to cover current liabilities.
As a model of fiscal prudence, let’s take Apple (NASDAQ: AAPL) as an example:
Surprisingly, Apple does not have the best looking ratios. This is due to the fact Apple has most of its assets invested in long term investments. However, Apple does have a comparatively low level of liabilities and inventories, so current assets can easily cover current liabilities.
One of the best looking Acid Ratios in the S&P 500 belongs to Cisco Systems (NASDAQ: CSCO)
Unlike Apple, Cisco holds most of its assets as cash and short term investments. This gives it a significantly better Acid and Current ratio. In fact, Cisco has enough current assets to cover all of its liabilities, current and long term.
On the other hand, some of the worst looking ratios belong to Carnival Corporation (NYSE: CCL)
Carnival has most of its assets marked as Property/Plant--presumably these are cruise ships. This is a case of an illiquid assets accounting for the main bulk of the balance sheet. If Carnival breached its borrowing covenants it would defiantly not be able to sell off its ships fast enough, or at the right price to pay off its debtors.
Heavy Reliance on Inventories
As I have already stated, the Acid ratio is a good method of testing the current assets available for immediate use. This, of course, excluded inventories.
3M Co. (NYSE: MMM)
3M is an example of a company relying on strong inventories to bolster its balance sheet. When the Acid ratio is calculated it gives a different picture of the Current ratio. Current liabilities are still well covered by current assets, but the difference in the two ratios shows the heavy reliance on inventories used to bolster the balance sheet.
Another firm with a heavy reliance on inventories is Home Depot (NYSE: HD)
On a Current ratio, Home Depot looks to have sufficient assets to cover its current liabilities. However, stripping out inventories gives an Acid ratio of <1. This heavy reliance on unpredictable inventories could produce some big problems in the worst case scenario.
The Acid and Current ratio, are not definitive, and give a very small picture of the overall company. They can, however, be very good tools in assessing the financial situation of an investment, quickly allowing a prospective investor to get an overview of the integrity of a company's balance sheet.
RupertHargreav has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple, The Home Depot, and 3M Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!