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
to the company itself, rather than the stock’s price movement or the overall state of the market.
Liquidity Ratio
Analysis
Liquidity ratios are used to determine 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 comfortably 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 Fundamental Focus, we investigate liquidity 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 database, 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
use the data offered there rather than
downloading several years of reports
from another source.
You may also find financial statement data at websites such as Yahoo!
Finance and SmartMoney.com.
Table 1 provides all the revelvant
data for calculating these ratios.
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:
Current Ratio
Quick Ratio = (Cash & Equivalents + ShortTerm Investments + Accounts Receivable) ÷
Current Liabilities
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-
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 shortterm investments are $0. Current liabilities are $13,100,000 for the year.
Plugging these figures into our formula gives us a quick ratio of 0.863,
rounded to 0.9, for fiscal-2010.
Cash Ratio
The cash ratio is the most conservative of the three liquidity ratios
covered in this article. As the name
implies, this ratio is simply the ratio
of cash and equivalents compared
to current liabilities. This ratio looks
only at assets that can be most easily
used to pay off short-term debt, and
it disregards receivables and shortterm investments. The argument for
using the cash ratio is that receivables
and short-term investments often
cannot be liquidated in a timely manner. Receivables can be sold, or monetized, but the firm will not be able
to get the full value of the receivables
sold. Keep in mind that, due to their
Table 1. Financial Statement Data for J. Alexander’s Corp. (JAX)
Cash & equivalents ($ thous)
Accounts receivable ($ thous)
Short-term investments ($ thous)
Inventories ($ thous)
Other current assets ($ thous)
Total current assets ($ thous)
Total current liabilities ($ thous)
2010
$8,600
$2,700
$0
$1,300
$1,300
$13,900
$13,100
2009
$5,600
$3,400
$0
$1,300
$1,500
$11,800
$15,200
2008
$2,500
$3,900
$0
$1,400
$2,700
$10,500
$13,000
2007
$11,300
$3,400
$0
$1,300
$2,500
$18,500
$14,100
2006
$14,700
$2,300
$0
$1,300
$2,300
$20,600
$13,700
Source: AAII’s Stock Investor Pro, Thomson Reuters.
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Computerized Investing
be slightly higher. Either
J. Alexander’s to its sector and indusformula works as long
try medians. As you can see, both the
J. Alexander’s Corp. (JAX)
as you remain consist in
company’s current and quick ratios
2010 2009
2008
2007 2006
your analysis. For our
dipped significantly below the sector
Current ratio (X)
1.1
0.8
0.8
1.3
1.5
analysis here, we use the
medians during the economic recesQuick ratio (X)
1.0
0.7
0.7
1.2
1.4
figures provided by Stock
sion. Once again, this should come as
Cash ratio (X)
0.7
0.4
0.2
0.8
1.1
Investor Pro.
no surprise. While it is to be expected
McCormick & Schmick’s Seafood Restaurant (MSSR)
As we stated, firms with
that the services sector may experi2010 2009
2008
2007 2006
higher liquidity ratios are
ence slight difficulties during tough
Current ratio (X)
0.5
0.6
0.6
0.7
0.8
better able to meet their
economic times, it makes sense that
Quick ratio (X)
0.4
0.5
0.5
0.6
0.6
short-term obligations.
high-end restaurants are especially
Cash ratio (X)
0.1
0.2
0.1
0.1
0.3
From Table 2, you can
affected. The same can be said for the
Source: AAII’s Stock Investor Pro, Thomson Reuters.
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.
high liquidity, short-term Treasuries
board compared to McCormick &
Consumers may opt for fast food or
are considered cash equivalents, not
Schmick’s. For fiscal-2010, McCorlow-cost diners rather than steak and
short-term investments. The formula
mick & Schmick’s has a cash ratio
seafood. Overall, J. Alexander’s liquidfor the cash ratio is as follows:
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
Cash Ratio = Cash & Equivalents ÷ Current
of its short-term obligations.
been strong compared to the industry.
Liabilities
Another major observation can be
made using time-series analysis. RaConclusion
For fiscal-2010, the calculation for
tios for both firms were the strongest
Liquidity ratios are just a small part
cash ratio involves using $8,600,000
at the end of 2006, bottomed out in
of fundamental analysis. Looking only
for the numerator of the equation
late 2008, and rebounded in 2009
at these ratios would lead you to beand $13,100,000 for the denominathrough the end of 2010. This can be
lieve that J. Alexander’s is the stronger
tor. After plugging in the numbers,
easily explained by the recession we
firm. Furthermore, the ratios imply
we find that the cash ratio for fiscalexperienced in 2008. J. Alexander’s
that the best time to invest would
2010 is 0.656, rounded to 0.7.
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
Interpreting the Ratios
side to the story. McCormick &
seafood. The firms are classified as
Calculating the ratios is typically
Schmick’s is a larger firm with more
consumer cyclical, meaning they will
the easy part. The difficulties lie in
locations. Weaker liquidity ratios
follow the market cycle. As our econanalyzing the ratios, interpreting their
may be due to aggressive expansion
omy fell into recession, it was natural
meaning and making an educated
policies. As always, it is prudent not
that fewer people dined at high-end
investment based on the findings. As
to rely too heavily on a single set of
restaurants. The two firms have less
with any fundamental ratio analysis,
ratios, but to research the firm as a
cash coming in and will possibly have
performing a time-series analysis, a
whole.
to borrow more in order
competitive analysis and industry and
to weather the downturn.
sector analyses are good first steps.
Table 3. Sector and Industry Comparison
Both of these scenarios
In Table 2, the liquidity ratios
will place an added burfor 2006 through 2010 are listed
Current Ratio (X)
den on liquidity ratios.
for J. Alexander’s and one of its
2010 2009
2008
2007 2006
Unsurprisingly, as the
main competitors, McCormick &
J. Alexander’s (JAX) 1.1
0.8
0.8
1.3
1.5
economy recovered, so
Schmick’s Seafood Restaurants
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
(MSSR). Note that the quick ratio
Finally, we perform
we calculated for J. Alexander’s for
Quick Ratio (X)
an industry and sector
2010 is slightly different than the
2010 2009
2008
2007 2006
analysis. J. Alexander’s is
one shown in Table 2. Instead of
J. Alexander’s (JAX) 1.0
0.7
0.7
1.2
1.4
in the services sector and
short-term investments, Stock InvesSector (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
tor Pro uses marketable securities
Table 3 compares the curin the numerator of the equation,
Source: AAII’s Stock Investor Pro, Thomson Reuters.
rent and quick ratios for
causing its quick ratio calculation to
Table 2. Comparing Liquidity Ratios
Fourth Quarter 2011
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