Liquidity

In depth

A ladder of measures

The liquidity ratios form a ladder. Each step leaves out the current assets that are furthest from cash, so each answers a harsher version of the same question.

• Current ratio: all current assets against all current liabilities. It assumes every current asset will become cash in time to meet the liabilities.
• Quick ratio (acid test): only cash, short-term investments and receivables, the assets that are already money or a customer’s promise to pay on a fixed date. Inventory (it must be sold first), prepayments (they will never come back as cash) and a contract asset (it is not yet billable) are left out.
• Cash ratio: cash and short-term investments only. It asks what could be paid tomorrow if nothing more came in.
• Operating cash flow ratio: cash from operations for the period against current liabilities at its end. It replaces a stock of assets with a flow: how much of what is owed would one period’s operations pay off?

None of these has a single right value. OpenStax’s Principles of Finance calls a 2 : 1 current ratio “actually quite high for most companies and most industries”, and notes that many firms operate successfully with a cash ratio below 1, since idle cash earns little. What matters is the comparison: with the same business in earlier years, with similar businesses, and with what the business must pay soon.

What goes in, and why

The balance sheet decides what is current; the analyst decides how close to cash each current item really is. Lantern’s 2027 balance sheet has examples of almost every kind.

The liabilities need the same care. Accounts payable, wages, interest and income taxes payable are paid in cash, mostly within weeks. Unearned revenue ($9,060 of deposits, workshop places and subscriptions) is different: the cash has already been received, and the obligation is settled by delivering the events, workshops and coffee. It needs cash only if customers ask for refunds, or for the costs of delivering. The current portion of long-term debt ($27,091) is principal Lantern must repay in 2028: the Coastline note ($10,000, due 1 March 2028), the van note’s instalment ($5,000) and the brewer plan’s 2028 principal ($12,091). The line of credit ($24,000 drawn) is shown as current. The current portion of operating lease liabilities ($37,010) is the part of the cafés’ lease liability that the 2028 rent payments will reduce.

Why Lantern’s ratios fell

The quickest way to explain a change in working capital uses the accounting equation. Split each side into current and noncurrent parts: current assets + noncurrent assets = current liabilities + noncurrent liabilities + equity. Rearranged:

Working capital is the part of the long-term funding (equity and long-term debt) that is not tied up in long-term assets. It rises when the business keeps profits or borrows long-term, and falls when it buys long-lived assets or when long-term debt moves into the coming year. Lantern’s working capital fell by $85,620 in 2027, and the identity splits the fall into four causes.

The biggest cause is the cafés. Lantern paid $36,000 for the fit-out and $18,000 for the machines in cash: long-lived assets bought with money that had been working capital. The statement of cash flows tells the same story from the other side. Operations brought in $8,341; buying the fit-out and machines took $54,000; repaying the van note and the brewer plan took $12,750 and the dividend $2,000. The $24,000 drawn on the line of credit filled part of the gap, and cash fell by $36,409. In effect Lantern paid for five-year assets with cash and with a loan due within a year, which is why its working capital went below zero.

The next two causes are not new spending but the passage of time. The leases put $37,010 of lease liability into current liabilities: the principal part of 2028’s $48,000 of rent. The Coastline note, borrowed in 2026 for two years, is now due on 1 March 2028, and the brewer plan’s 2028 instalments are current. Look at Lantern’s current liabilities by kind and the point is plain: the trade items (payables, wages, interest, unearned revenue and tax) rose only from $21,289 to $26,436. Of the $88,248 increase in current liabilities, debt and leases account for $83,101: current debt up $46,091 (to $51,091) and the current lease liability of $37,010.

The contract asset hides a further weakness. Without it the current ratio would be 0.25, not 0.52. It will turn into cash, $41,120 if the CPI estimate holds, on 31 March 2028, a month after the Coastline note’s $10,000 falls due. Liquidity is a calendar question as much as a ratio question, and the next cash-flow lessons return to what the contract asset means for the quality of 2027’s profit.

What the balance sheet does not show

• Undrawn facilities. Lantern can still draw $6,000 on its $30,000 line of credit. Cash a business can borrow at short notice is liquidity that no ratio counts; companies describe their facilities in the notes and in management’s discussion.
• Timing within the year. The ratios compare totals, not dates. Wages due on 5 January and a note due on 1 March count the same.
• Seasonality. A balance sheet is a photograph of one day. Lantern’s year ends just after its December gift peak, when stock has been sold and cash collected; another date would give other ratios.
• The owner. A small company’s owner can often lend to it or invest more. That is support, not liquidity of the business itself, and a lender will not count on it unless it is written down.

Why cafés and restaurants run low current ratios

A business that is paid at the till holds few receivables, and one that sells fresh food and drink holds little stock. Its suppliers, meanwhile, give it normal trade credit. Its current assets are therefore small compared with what it owes, and a current ratio below 1 can be perfectly healthy if cash keeps arriving every day. Starbucks is the clearest example.

Source: Starbucks Corporation Form 10-K for the fiscal year ended 29 September 2024, consolidated balance sheets and statements of cash flows.

Two of Starbucks’ largest current liabilities make the ratio look worse than the position is. The stored-value card liability is money customers have already paid onto their cards; it is settled with coffee, not cash. The current operating lease liability is rent on the stores that produce the cash. Against both stand $6,095.6 million of operating cash flow in a year, enough to pay two-thirds of all current liabilities. Lantern’s 2027 operating cash flow ratio, 0.07, is the real difference: its cafés now give it a café’s balance sheet without, yet, a café chain’s cash flow.

For comparison, Harbourline Roasters, the fictional roaster from F00, has a current ratio of 1.50 and a quick ratio of 0.83. A roaster holds green and roasted coffee and sells to shops on credit, so its current assets are larger. Comparing Lantern with a peer means choosing one with the same business model, and Lantern is now a mixture: part café, part online shop, part caterer.

Comparing a ten-month year with a twelve-month one

The current, quick and cash ratios compare two balances at one date, so the length of the period before that date doesn’t enter them: 2026’s ratios compare directly with 2027’s. The operating cash flow ratio does mix a flow with a balance. Lantern’s 2026 cash from operations, $39,940, covers ten months; annualised (× 12 ÷ 10) it would be $47,928 and the ratio 1.82 rather than 1.52. Annualising assumes the missing two months look like the average ones, and Lantern’s first ten months included its December peak, so treat the 1.82 as an upper figure.

Window dressing

Window dressing means arranging transactions around the year end so that the balance sheet looks better than the business’s normal position. The common moves: paying suppliers just before the year end, delaying purchases, chasing collections into December, or borrowing on 30 December and repaying on 2 January. Whether a move helps depends on whether the ratio is above or below 1. Paying a liability with cash takes the same amount off both totals: above 1 that raises the ratio, below 1 it lowers it.

• At the end of 2026 (ratio 2.15), paying $6,000 of payables on 31 December would have raised the current ratio to 2.49 without making Lantern any more able to pay its bills.
• At the end of 2027 (ratio 0.52), the same payment would lower it to 0.49. Drawing the last $6,000 of the line of credit and holding the cash would instead raise it to 0.54, by adding the same amount to both totals.

An analyst guards against window dressing by comparing the year end with quarterly figures where they exist, by reading the cash-flow statement for unusual December movements, and by checking whether short-term borrowing at the year end matches the interest paid during the year.

Covenants in outline

Lenders write liquidity tests into loan agreements. A covenants clause might require a minimum current ratio, tested on the borrower’s quarterly or annual statements; failing it is a default that lets the lender demand repayment, raise the rate or impose conditions, although lenders often agree a waiver instead. The agreement defines the ratio, and the definition matters: whether operating lease liabilities, the current portion of the lender’s own loan or the drawn line of credit count as current liabilities can decide whether a borrower passes. The applied example below tests Lantern’s 2027 balance sheet against the 1.2 minimum in the loan Coastline is discussing for 2028.