Chapter 14 Financial Statement Analysis 647
An analysis of a firm’s current position normally includes determining the current
ratio and the quick ratio. The current and quick ratios are most useful when analyzed
together and compared to previous periods and other firms in the industry.
Thecurrent ratiois computed by dividing the total current assets by the total cur-
rent liabilities. For Pixar and DreamWorks, the current ratios are shown below.
While Pixar has slightly more working capital than DreamWorks, working capital
is not a relative measure of current position when making comparisons between firms
or across time. Rather, the current ratio is a relative measure of current position. This
ratio is 17.10 for Pixar and 4.76 for DreamWorks. A current ratio greater than 1.0 would
indicate that a firm has sufficient current assets to meet short-term claims. Thus, most
analysts would expect a current ratio greater than 1.0. Current ratios that exceed 1.5
are often considered acceptable for most industries, while a current ratio in excess of
2.0 is excellent and would indicate capacity for short-term borrowing. Thus, both Pixar
and DreamWorks have excellent current positions.
Quick Ratio
The current ratio does not consider the makeup of the current assets. To illustrate the
importance of this consideration, the current position data for Lincoln Company and
Jefferson Corporation as of December 31, 2006, are as follows:
Pixar DreamWorks
(in millions, (in millions,
except ratio) except ratio)a. Current assets $939.00 $727.80
b. Current liabilities 54.90 152.90
Working capital (ab) $884.10 $574.90
Current ratio (a ÷ b) 17.10 4.76
Lincoln Jefferson
Company Corporation
Current assets:
Cash $ 90,500 $ 45,500
Marketable securities 75,000 25,000
Accounts receivable (net) 115,000 90,000
Inventories 264,000 380,000
Prepaid expenses 5,500 9,500
Total current assets $550,000 $550,000
Current liabilities 210,000 210,000
Working capital $340,000 $340,000
Current ratio 2.6 2.6Both companies have a working capital of $340,000 and a current ratio of 2.6. But the
ability of each company to pay its current debts is significantly different. Jefferson
Corporation has more of its current assets in inventories. Some of these inventories
must be sold and the receivables collected before the current liabilities can be paid in
full. Thus, a large amount of time may be necessary to convert these inventories into
cash. Declines in market prices and a reduction in demand could also impair Jefferson’s