V11: Liquidity (Quick) — how to analyse it

Liquidity is survival. A profitable company can go into bankruptcy if it cannot pay bills on time. A liquidity crisis kills faster than a profitability crisis.

This is V11 — Liquidity (Quick) in the AKM1 model: one of the 20 variables that together determine whether a company is an institutional quality stock or a collection of stories. In this article you get the variable explained, how to compute it yourself, and how three of history's greatest investors would have interpreted it.

Why the variable exists

Liquidity analysis has existed since early merchant capitalism. Venetian and Dutch merchants in the 1500s-1600s understood the importance of having cash to survive shipping crises and war. Benjamin Graham and David Dodd in 'Security Analysis' (1934) formalised the quick ratio as the 'acid-test ratio' — the name comes from the goldsmith's test where acid was used to verify precious metals. Graham wanted an equally 'safe' test for companies. During the Great Depression thousands of companies went into bankruptcy not because of a solvency deficit (they were solvent on paper) but because of a liquidity deficit — they could not pay short-term liabilities when the banks demanded immediate repayment.

Liquidity — short-term survival

The dividing line between liquidity and solvency A company can be solvent (lower liabilities than assets) and still go into bankruptcy — if it cannot pay its short-term liabilities on time. This is the difference between solvency (long-term viability) and liquidity (short-term survival). Solvency is about the company's total balance sheet — are the assets larger than the liabilities? Liquidity is about the company's cash flow — can the company pay bills that fall due this month? A company with 1 billion in assets and 500 million in liabilities is solvent, but if 600 million of the liabilities fall due tomorrow and the company only has 100 million in cash — it goes into bankruptcy. Liquidity is the most acute form of financial risk. AKM1 measures liquidity via the quick ratio (also called the 'acid-test ratio'): (current assets − inventory) / short-term liabilities. >1,0 is considered safe; <0,5 is acute crisis. 📖 DEFINITION Quick ratio (Acid Test Ratio) = (Current assets − Inventory) / Short-term liabilities.

Computing liquidity in practice

Computation steps Step 1: Identify current assets in the balance sheet. These are found under the heading 'Current assets' and consist of liquid funds, accounts receivable, inventory, and other current assets. Step 2: Identify inventory — a separate item in the balance sheet. Step 3: Identify short-term liabilities — under the heading 'Short-term liabilities' (accounts payable, used overdraft credit, short-term loans, accrued costs). Step 4: Compute quick ratio = (current assets − inventory) / short-term liabilities. Step 5: Alternatively compute the 'current ratio' = current assets / short-term liabilities (less conservative). Step 6: Compare with the industry average. A company with a quick ratio of 1,0 can be good for retail (which has low inventory) but bad for industry (which has long customer credit). ✓ TIP Compute both the quick ratio and the current ratio.

Liquidity traps and illusions

The cash illusion A large cash gives a good quick ratio, but it can be an illusion. Three problems: 1) The cash is 'earmarked' — the company has received cash from a share issue for a specific investment. PREC after the 2021 issue had high cash, but it was intended for R&D investments, not to cover short-term liabilities. 2) The cash is 'locked' — foreign subsidiaries have cash that cannot be repatriated without tax. Apple pre-2017 had 200+ billion USD abroad. 3) The cash is 'taken' — the company has an overdraft credit that is fully used; the next bill to be paid has no source. Read the notes to the accounts on 'Liquid funds' for restrictions.

Three perspectives on liquidity (quick)

Peter Lynch: Lynch always checked liquidity — 'A company can be profitable on paper but die if it cannot pay its bills.' He preferred a quick ratio > 1.5. Lynch warned against companies with a quick ratio < 1.0: 'They live dangerously close to the edge.'

Benjamin Graham: Graham required a quick ratio > 1.0 for the 'defensive investor'. He argued that liquidity is the first line of defence against bankruptcy. Graham's rule: 'A company with a quick ratio < 0.5 is a bankruptcy-waiting-to-happen.' He combined liquidity with debt to assess financial stability.

AK1's interpretation: AKM1 weight 5%. Liquidity is assessed on two levels: (1) quick ratio — can the company pay short-term liabilities, (2) cash burn — how long does the cash last under negative cash flow. AKM1 combines V11 with V19 (cash burn) — low liquidity + high burn = runway below 12 months = acute risk.

Go deeper

Want to practise with worked examples, chapter by chapter? The course Liquidity (Quick) (V11) contains 6 chapters, Lynch and Graham perspectives and how AK1 uses the variable in the wave matrix. See also the complete guide to Swedish stock analysis for how all 20 variables fit together.

FAQ

What is the quick ratio — and why is inventory excluded?

The quick ratio (acid test ratio) measures whether a company can pay its short-term liabilities with assets that quickly become cash: (current assets − inventory) / short-term liabilities. Inventory is excluded because it often takes time to sell, and then at a discount — clothes, semi-finished goods and construction in progress cannot be converted into cash overnight. The measure answers the question: if revenues stopped tomorrow, could the company pay its bills?

How do I calculate the quick ratio in practice?

Go to the balance sheet and pick three items: current assets (cash, accounts receivable, inventory and other), inventory, and short-term liabilities. Subtract inventory from current assets and divide by short-term liabilities. As a complement, many also calculate the current ratio (current assets / short-term liabilities), which is less conservative. The course Liquidity (Quick) (V11) demonstrates the calculation with concrete worked examples.

What do different quick-ratio levels mean?

As a rule of thumb, a quick ratio above 1,0 is considered safe — the company then has more fast assets than short-term liabilities. Below 0,5 is regarded as an acute situation, and Peter Lynch warned that companies under 1,0 live dangerously close to the edge. But interpretation depends on the industry: a retailer with fast revenue turnover can manage on lower levels than an industrial company with long credit periods. Always compare with the industry average.

Can a profitable company end up in bankruptcy because of poor liquidity?

Yes — that is the difference between solvency and liquidity. A company can have assets exceeding its liabilities yet still end up in bankruptcy if the liabilities fall due before the assets can be sold. During the Great Depression, thousands of companies went into bankruptcy for precisely this reason: they were solvent on paper but lacked cash when the banks demanded repayment. Liquidity is therefore regarded as the most acute form of financial risk.

This is educational financial analysis, not investment advice.