Michael D. Slaubaugh, Ph.D. (Contact Author)
Associate Professor of Accounting
Department of Accounting and Finance
School of Business and Management Sciences
Indiana University-Purdue University Fort Wayne
Fort Wayne, Indiana 46805
slaubau@ipfw.edu

Kathy S. Pollock, Ph.D.
Assistant Professor of Accounting
Indiana University-Purdue University Fort Wayne

George Schmelzle, Ph.D.
Associate Professor of Accounting
Indiana University-Purdue University Fort Wayne

This paper critiques the teaching of the 2:1 and 1:1 rules of thumb for the current and quick ratios, respectively, in introductory accounting courses. These ratios are calculated for 38 industries and tested for significant differences from the rules of thumb. Of the 38 industries examined, 20 had current and quick ratios that were significantly different from the rules of thumb. The paper includes tables suitable for distribution to students to promote discussion about using industry averages rather than solely relying on rules of thumb when analyzing the financial position of a company.

Teaching Current and Quick Ratios Rules of Thumb

Michael D. Slaubaugh, Ph.D.
Kathy S. Pollock, Ph.D.
George Schmelzle, Ph.D.

Introduction

Most financial accounting textbooks include a segment on financial statement analysis. Among the numerous ratios discussed in these textbooks are two common liquidity ratios: the current ratio and the quick (a.k.a., acid-test) ratio. Virtually all textbooks mention that the rules of thumb for the current and quick ratios are 2:1 and 1:1, respectively, and these rules have been accepted by a majority of financial analysts for nearly a century (Kristy, 1994). However, the rules of thumb in today’s complex economic and global business environments are only very general guidelines. A majority of the financial accounting textbooks we surveyed did not give students an appreciation of how the ratios can vary by industry or discuss what other factors can influence the ratios. Therefore, these students are left with the impression that these rules of thumb are more universal than they are in reality for many businesses. Financial analysts and academicians themselves do not always agree on the appropriate interpretation of the rules of thumb. For example, Kristy (1994) suggests that a 2:1 current ratio should be considered a standard of excellence, whereas Gallinger (1997a) states that a 2:1 current ratio should be considered merely adequate. Gallinger supports the latter point of view by noting that detailed studies of bankrupt firms indicate that the firms failed despite averaging significantly above 2:1 for the current ratio in the five years prior to bankruptcy. In the introductory accounting courses taught at our institution, the textbooks we have adopted in the past mention the 2:1 and 1:1 rules of thumb without qualification. This became problematic when a recently used textbook included these rules of thumb as well as the annual reports of two major corporate entities, Coca-Cola and PepsiCo, both of which had ratios significantly lower than those benchmarks. For example, Coca-Cola had a current ratio of 0.74, yet both students and financial analysts perceive Coca-Cola to be a highly successful and viable business. Therefore, our students tend to be bewildered by the rules of thumb when they see direct evidence of these rules not being met by firms such as Coca-Cola and PepsiCo.

As with the interpretation of the rules of thumb, financial analysts do not provide consistent guidance on the desired minimum ratios. Kristy (1994) defines a current ratio below 1:1 to be unsatisfactory, whereas Fridson (1992) notes that there are some financially unassailable corporations that contradict the general rule by regularly maintaining current ratios of less than 1:1, resulting in negative working capital balances. Coca-Cola would be an example of such a firm that is able to succeed due to its access to short-run bank credit. Therefore, a poor current ratio does not necessarily indicate a potential credit problem. Fridson (1992) notes that the current and quick ratios have limited value as indicators of creditworthiness unless the ratios of the firm are compared with others in the same industry group, since liquidity requirements and terms of trade vary from industry to industry. In teaching financial statement analysis and the interpretation of ratios, it would be beneficial to provide evidence as to what represents an appropriate current and quick ratio across industry classifications, as well as industry size, rather than presenting a global rule that is not representative of all industries. The objective of our study is to present industry information in a format that students will find easy to understand and which will allow students to make more informed financial decisions in real-world settings. Peles and Schneller (1979) and Huff, Harper, and Eikner (1989) have previously addressed the appropriateness of the current and quick ratio rules of thumb across industry classifications and/or firm size. Our paper has three advantages over these previous works. First, the data collected for our study is more current than either Peles and Schneller (1979) or Huff, Harper, and Eikner (1989). Domestic and global economic conditions have changed the financial management and general operating philosophies of many industries since those studies were conducted. Second, Huff, Harper, and Eikner (1989) present their results from an academic perspective with tables that are difficult to understand by laypersons, especially students of introductory accounting. Third, Huff, Harper, and Eikner (1989) lump industries into broad first digit SIC classifications, which means that a wide variety of firms are included in these broad classifications. This paper focuses on much narrower SIC classifications so that the averages are more representative of a particular industry segment. Fourth, the paradigm shift of introductory accounting textbooks towards a user perspective increases the importance of interpreting financial ratios. The data presented in Table 1 can aid in the classroom discussion of the rules of thumbs for the current and quick ratios and provides a springboard for identifying other factors that can affect liquidity ratios for a given firm. Asking the students to consider why it works for some companies to be above and other companies below the rules of thumb allows for more in-depth considerations of how companies operate. The annual reports of over 1,000 firms in 38 different industry classifications were surveyed to document what the typical firm in each industry would expect to achieve for the current and quick ratios. Our results document variation across industry type and industry size that sometimes deviates significantly from the historical rules of thumb for the current and quick ratios. Instructors can use the results of our survey to stress these variations to their students.

Methodology

Compustat was used to gather the data for all tables presented in this study.1 In selecting industries to be surveyed, we attempted to choose those that would be familiar to students. We selected the year 2000 to compute the ratios due to the availability of the data at the time of the study. Instructors could require students to calculate these industry ratios and prepare a trend analysis using more recent data from Compustat. In addition to the current and quick ratios, information on each company's total sales and assets was collected in order to assess the impact of firm size on the magnitude of the ratios.

Results

Table 1presents key financial information by industry including the number of companies, the average current and quick ratio, the average total assets, and the average total sales. Thirty-eight different industries representing a broad range of manufacturing, service, and retail companies were selected. A total of 2,853 firms across those 38 industries were surveyed to calculate averages within each industry. Both small and large industries were examined. Average total assets ranged from $185.35 million for the home shopping industry to $49.629 billion for the automotive manufacturing industry. Average total sales ranged from $272.72 million for the home shopping industry to $48.817 billion for the automotive manufacturing industry. The wide variation in the sizes of the industries allows for the examination of the current and quick ratios for both small and large industries. Current Ratio. The current ratios in Table 1 ranged from a high of 4.80 for the "retail, home shopping" to a low of 0.82 for "restaurants." Of the 38 industries studied, 20 industries had a current ratio that was significantly different (at the 0.10 level of significance) than the 2:1 rule of thumb found in most financial accounting textbooks. Twelve of these 20 industries had a current ratio significantly above the 2:1 rule of thumb, while the other eight industries were significantly below the benchmark. These results are consistent with Peles and Schneller (1979) with regard to variation across industries. Table 2 groups these 20 industries into the 12 that fell significantly above the 2:1 benchmark (Panel A) and the eight industries that fell significantly below (Panel B) along with the total assets and asset rank for each industry. Consistent with the results of Huff, Harper, and Eikner (1979), both panels in Table 2 suggest that size, based on total assets, may be a factor in influencing the magnitude of the current ratio. With the exception of broadcasting, computer hardware, and department stores, all of the industries that had a current ratio significantly higher than 2:1 (Panel A) had total assets of less than $900 million and ranked in the bottom half of the industries studied based on asset size. Similarly, those industries that had a current ratio lower than 2:1 (Panel B), with the exception of gaming and restaurants, had total assets in excess of $1.6 billion and ranked in the top half of the industries in the sample. Quick Ratio. The quick ratios in Table 1 ranged from a high of 3.84 for "retail, home shopping" to a low of 0.39 for both "retail, general merchandise chains" and "retail, computer & electronics." Of the 38 industries studied, 20 industries had a quick ratio that was significantly different at the 0.10 level than the 1:1 rule of thumb included in most financial accounting textbooks. Since the two ratios are highly correlated, it is not surprising that most of the industries that had a current ratio significantly different from the 2:1 rule of thumb also had a quick ratio significantly different from the 1:1 rule of thumb. Table 3 groups these 20 industries into the 12 that fell significantly above the 1:1 benchmark (Panel A) and the eight that fell significantly below (Panel B) along with the total assets and asset rank for each industry. As with the current ratio results, industry size appears to influence the magnitude of the quick ratio. In general, industries with smaller asset bases tended to have quick ratios that were significantly higher than the 1:1 rule of thumb. Similarly, the four largest industries had quick ratios that were significantly lower, at the 0.10 level, than the benchmark.

Conclusion

The results of our survey represent a convenient means of introducing students to some factors that cause variations in the current and quick ratios. Additionally, classroom discussions can include how industries well below the rules of thumb survive and why some industries tend to have ratios well above the benchmarks. Once students understand that the rules of thumb are not always representative of a particular industry or size classification, the instructor can introduce other factors that affect the ratio, such as individual company size (Huff, Harper, and Eikner, 1989), analyzing trends in the ratios (Fridson, 1992), or labor intensity (Peles and Schneller, 1979). In beginning accounting courses, students could be asked to complete assignments that extend and apply what is discussed in class. To illustrate trend analysis, students might be required to compute the current and quick ratios using more recent data from Compustat and compare the results to the year 2000 ratios presented here. Another potential assignment might require them to research other ratios (e.g., return-on assets) by industry and look for trends over time or the influence of other attributes such as company size. If an annual report is included in the text, students could be asked to find industry ratio information for the appropriate year and compare that to the featured company's ratio to assess its financial position. In advanced accounting courses, the instructor could introduce other ideas related to the interpretation of liquidity ratios. For example, Kamath (1989) and Lancaster, Stevens, and Jennings (1998) suggest that the current and quick ratios are measures of static liquidity, whereas it is better to capture dynamic liquidity by analyzing the cash conversion cycle. Since the current and quick ratios can change rapidly over a short period of time and are susceptible to management manipulation, Fleming (1986) suggests five other factors that should be addressed in determining the liquidity of a firm, such as a readily accessible line of credit, the liquidity of noncurrent assets, and future profit expectations. Alternatively, Kleiman (1992) and Gallinger (1997b) recommend other measures of liquidity they consider superior to the current and quick ratios and which might be of interest to students in advanced accounting courses.

References

Fleming, M.M.K. 1986. The current ratio revisited. Business Horizons (May/June): 74-78.

Fridson, M.S. 1992. Financial statement analysis in perilous times. Corporate Cashflow (October): 46.

Gallinger, G. 1997a. The current and quick ratios: Do they stand up to scrutiny? Business Credit (May): 22-23.

Gallinger, G. 1997b. The defensive interval: A better liquidity measure. Business Credit (September): 26-28.

Huff, P.L., R.M. Harper, and A.E. Eikner. 1989. Are there differences in liquidity and solvency measures based on company size? American Business Review (June): 96-106.

Kamath, R. 1989. How useful are liquidity measures? Journal of Cash Management (January/February): 24-28.

Kleiman, R.T. 1992. Liquidity measures: New developments alleviate old deficiencies. Business Credit (October): 9-13.

Kristy, J.E. 1994. Conquering financial ratios: The good, the bad, and the who cares. Business Credit (February): 14-19.

Lancaster, C., J.L. Stevens, and J.A. Jennings. 1998. Corporate liquidity and the significance of earnings versus cash flow. Journal of Applied Business Research (Fall): 27-38.

Peles, Y.C., and M.I. Schneller. 1979. Liquidity ratios and industry averages - new evidence. Abacus (June): 13.

Table 1: Average current ratio, quick ratio, total assets, and net sales by industry
(in alphabetical order)

Panel B: Eight industries significantly lower than the 2:1 rule of thumb
(in descending order by magnitude of ratio)

Table 3: Asset size and rank of the 20 industries with mean quick ratios significantly different than the 1:1 rule of thumb
(at the 0.10 level of significance)

Panel B: Eight industries significantly lower than the 1:1 rule of thumb
(in descending order by magnitude of ratio)

1 The data used in the sample is available from the authors upon request. .