This column covers fundamental analysis, which involves examining a company’s financial
statements and evaluating its operations. The analysis concentrates only on variables directly related
Liquidity Ratio
Analysis
Liquidity ratios are used to deter-
mine a company’s ability to meet its
short-term debt obligations. Investors
often take a close look at liquidity
ratios when performing fundamental
analysis on a firm. Since a company
that is consistently having trouble
meeting its short-term debt is at a
higher risk of bankruptcy, liquidity
ratios are a good measure of whether
a company will be able to comfort-
ably continue as a going concern.
Any type of ratio analysis should be
looked at within the correct context.
For instance, investors should always
look at a company’s ratios against
those of its competitors, its sector
and its industry and over a period of
several years. In this issue’s Funda-
mental Focus, we investigate liquid-
ity ratios using time-series analysis,
competitive analysis and sector and
industry analysis.
As an example of how to properly
examine liquidity ratios, we will
use the financial statement data for
J. Alexander’s Corp. (JAX) found in
AAII’s fundamental research da-
tabase, Stock Investor Pro. While
you can access financial statements
directly on company websites,
J. Alexander’s only offers two years
of balance sheets at its site. For
our purpose of examining trends in
liquidity ratios, we need several years
of financial statements in order to
gather all the data. And since Stock
Investor Pro contains yearly balance
sheet figures going back seven years,
our task is made much easier if we
Table 1. Financial Statement Data for J. Alexander’s Corp. (JAX)
Cash & equivalents ($ thous)
Accounts receivable ($ thous)
Short-term investments ($ thous)
Inventories ($ thous)
Other current assets ($ thous)
Total current assets ($ thous)
Total current liabilities ($ thous)
Source: AAII’s Stock Investor Pro, Thomson Reuters.
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to the company itself, rather than the stock’s price movement or the overall state of the market.
use the data offered there rather than
downloading several years of reports
from another source.
You may also find financial state-
ment data at websites such as Yahoo!
Finance and SmartMoney.com.
Table 1 provides all the revelvant
data for calculating these ratios.
Current Ratio
The current ratio is the first of
three financial ratios that we will
examine. The formula for the current
ratio is as follows:
Current Ratio = Current Assets ÷ Current
Liabilities
As stated earlier, liquidity ratios
measure a company’s ability to pay
off its short-term debt using assets
that can be easily liquidated. In this
case, the current ratio measures a
company’s current assets against its
current liabilities. Generally, higher
numbers are better, implying that the
firm has a higher amount of current
assets when compared to current
liabilities and should easily be able to
pay off its short-term debt.
As shown in Table 1, the company’s
2010 current assets are $13,900,000
and its 2010 current liabilities are
$13,100,000. Plugging these numbers
into our formula gives us a current
ratio of 1.061 (rounded to 1.1).
Quick Ratio
The quick ratio, also known as the
acid-test ratio, is a liquidity ratio that
is more refined and more stringent
than the current ratio. Instead of
using current assets in the numera-
2010 2009
$8,600 $5,600
$2,700 $3,400
$0 $0
$1,300 $1,300
$1,300 $1,500
$13,900 $11,800
$13,100 $15,200
tor, the quick ratio uses a figure that
focuses on the most liquid assets.
The main asset left out is inventory,
which can be hard to liquidate at
market value in a timely fashion. The
quick ratio is more conservative than
the current ratio and focuses on cash,
short-term investments and accounts
receivable. The formula is as follows:
Quick Ratio = (Cash & Equivalents + Short-
Term Investments + Accounts Receivable) ÷
Current Liabilities
Once again, taking a look at
the 2010 financial statements for
J. Alexander’s, we find that cash and
equivalents are $8,600,000, accounts
receivable are $2,700,000 and short-
term investments are $0. Current li-
abilities are $13,100,000 for the year.
Plugging these figures into our for-
mula gives us a quick ratio of 0.863,
rounded to 0.9, for fiscal-2010.
Cash Ratio
The cash ratio is the most conser-
vative of the three liquidity ratios
covered in this article. As the name
implies, this ratio is simply the ratio
of cash and equivalents compared
to current liabilities. This ratio looks
only at assets that can be most easily
used to pay off short-term debt, and
it disregards receivables and short-
term investments. The argument for
using the cash ratio is that receivables
and short-term investments often
cannot be liquidated in a timely man-
ner. Receivables can be sold, or mon-
etized, but the firm will not be able
to get the full value of the receivables
sold. Keep in mind that, due to their
2008 2007 2006
$2,500 $11,300 $14,700
$3,900 $3,400 $2,300
$0 $0 $0
$1,400 $1,300 $1,300
$2,700 $2,500 $2,300
$10,500 $18,500 $20,600
$13,000 $14,100 $13,700
Computerized Investing
 Table 2. Comparing Liquidity Ratios
J. Alexander’s Corp. (JAX)
2010 2009
Current ratio (X) 1.1 0.8
Quick ratio (X) 1.0 0.7
Cash ratio (X) 0.7 0.4
McCormick & Schmick’s Seafood Restaurant (MSSR)
2010 2009
Current ratio (X) 0.5 0.6
Quick ratio (X) 0.4 0.5
Cash ratio (X) 0.1 0.2
Source: AAII’s Stock Investor Pro, Thomson Reuters.
high liquidity, short-term Treasuries
are considered cash equivalents, not
short-term investments. The formula
for the cash ratio is as follows:
Cash Ratio = Cash & Equivalents ÷ Current
Liabilities
For fiscal-2010, the calculation for
cash ratio involves using $8,600,000
for the numerator of the equation
and $13,100,000 for the denomina-
tor. After plugging in the numbers,
we find that the cash ratio for fiscal-
2010 is 0.656, rounded to 0.7.
Interpreting the Ratios
Calculating the ratios is typically
the easy part. The difficulties lie in
analyzing the ratios, interpreting their
meaning and making an educated
investment based on the findings. As
with any fundamental ratio analysis,
performing a time-series analysis, a
competitive analysis and industry and
sector analyses are good first steps.
In Table 2, the liquidity ratios
for 2006 through 2010 are listed
for J. Alexander’s and one of its
main competitors, McCormick &
Schmick’s Seafood Restaurants
(MSSR). Note that the quick ratio
we calculated for J. Alexander’s for
2010 is slightly different than the
one shown in Table 2. Instead of
short-term investments, Stock Inves-
tor Pro uses marketable securities
in the numerator of the equation,
causing its quick ratio calculation to
Fourth Quarter 2011
be slightly higher. Either J. Alexander’s to its sector and indus-
formula works as long try medians. As you can see, both the
as you remain consist in company’s current and quick ratios
2008 2007 2006 your analysis. For our dipped significantly below the sector
0.8 1.3 1.5 analysis here, we use the medians during the economic reces-
0.7 1.2 1.4
0.2 0.8 1.1 figures provided by Stock sion. Once again, this should come as
Investor Pro. no surprise. While it is to be expected
As we stated, firms with that the services sector may experi-
2008 2007 2006 higher liquidity ratios are ence slight difficulties during tough
0.6 0.7 0.8 better able to meet their economic times, it makes sense that
0.5 0.6 0.6
0.1 0.1 0.3 short-term obligations. high-end restaurants are especially
From Table 2, you can affected. The same can be said for the
see that J. Alexander’s restaurant industry. The industry as
has significantly higher a whole may not suffer the declines
liquidity ratios across the that high-end restaurants experience.
board compared to McCormick & Consumers may opt for fast food or
Schmick’s. For fiscal-2010, McCor- low-cost diners rather than steak and
mick & Schmick’s has a cash ratio seafood. Overall, J. Alexander’s liquid-
of just 0.1, meaning that it only has ity figures are rebounding back toward
enough cash on hand to cover 10% the sector medians and have always
of its short-term obligations. been strong compared to the industry.
Another major observation can be
made using time-series analysis. Ra- Conclusion
tios for both firms were the strongest Liquidity ratios are just a small part
at the end of 2006, bottomed out in of fundamental analysis. Looking only
late 2008, and rebounded in 2009 at these ratios would lead you to be-
through the end of 2010. This can be lieve that J. Alexander’s is the stronger
easily explained by the recession we firm. Furthermore, the ratios imply
experienced in 2008. J. Alexander’s that the best time to invest would
and McCormick & Schmick’s are have been sometime in early 2009.
both high-end American restaurant However, there is often another
chains known for their steaks and side to the story. McCormick &
seafood. The firms are classified as Schmick’s is a larger firm with more
consumer cyclical, meaning they will locations. Weaker liquidity ratios
follow the market cycle. As our econ- may be due to aggressive expansion
omy fell into recession, it was natural policies. As always, it is prudent not
that fewer people dined at high-end to rely too heavily on a single set of
restaurants. The two firms have less ratios, but to research the firm as a
cash coming in and will possibly have whole.
to borrow more in order
to weather the downturn.
Both of these scenarios Table 3. Sector and Industry Comparison
will place an added bur-
Current Ratio (X)
den on liquidity ratios.
2010 2009 2008 2007 2006
Unsurprisingly, as the
J. Alexander’s (JAX) 1.1 0.8 0.8 1.3 1.5
economy recovered, so Sector (services) 1.2 1.2 1.3 1.3 1.4
did the liquidity ratios. Industry (restaurants) 0.8 0.8 0.8 0.8 0.8
Finally, we perform
Quick Ratio (X)
an industry and sector
2010 2009 2008 2007 2006
analysis. J. Alexander’s is
J. Alexander’s (JAX) 1.0 0.7 0.7 1.2 1.4
in the services sector and Sector (services) 1.0 1.0 1.0 1.0 1.0
the restaurants industry. Industry (restaurants) 0.7 0.7 0.6 0.7 0.6
Table 3 compares the cur-
Source: AAII’s Stock Investor Pro, Thomson Reuters.
rent and quick ratios for
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