The Loominary is a clothing manufacturer looking to expand and is ready to set a budget. Before the leadership team decides how much new debt they can carry, they need an accurate picture of their current liquidity.
They gather financial statements and find $48K cash between their bank accounts and checking accounts, $74K in marketable securities, and $139k in accounts receivable. Their total current asset calculation looks like this.
$261,000 total current assets = ($48,000 cash + $139,000 marketable securities + $74,000 accounts receivable)
The company’s total liabilities are listed as $115k on the balance sheet. So the quick ratio calculation looks like this:
2.27 quick ratio = $261,000 liquid assets / $115,000 current liabilities
The Loominary’s quick ratio indicates the company is in good financial shape. Leadership has even found room to take on additional liabilities to grow their business. They can check to see how much debt they can take on by reverse engineering the formula this way:
maximum healthy liability = liquid assets / quick ratio
If their bare minimum quick ratio is 1.5, then the calculation looks like this:
$174,000 maximum healthy liability = $261,000 liquid assets / 1.5 quick ratio
Now they can subtract current liabilities from hypothetical liabilities to see the maximum budget they can allow
$59,000 = $174,000 maximum healthy liability – $115,000 current liabilities
Remember: It’s always a good idea to discuss new liabilities with your financial advisor, mentor, and other trusted advisors.