In previous posts, we outlined how to use the financial statements of a water or wastewater system to calculate the key financial indicators of operating ratio (a measure of self-sufficiency), debt service coverage ratio (a measure of a system’s ability to pay its long-term debts), and days of cash on hand (a measure of a system’s financial security). Another key financial indicator is current ratio.
Current ratio, also known as quick ratio, is a measure of short-term liquidity or the ability to pay your current bills. It is most often calculated by dividing unrestricted current assets by current liabilities. In other words, could a water or wastewater system pay all of the bills currently sitting on someone’s desk with the cash it has on hand?
As we have stated before, key financial indicators are a way for a system to get a snapshot of its financial health and to determine whether it needs to make adjustments to its rates, and they should be calculated annually when financial statements are released.
Current ratio is calculated by dividing unrestricted cash, cash equivalents, and net receivables by the total current liabilities of the system. If the system is owned by a government that follows GASB 34 procedures for audited financial statements, all of these numbers can be found on the Statement of Net Position for the proprietary fund, formerly called the Statement of Net Assets.
A current ratio of 1.0 means that the water system has exactly enough money on hand to pay its current bills, and that is obviously the minimum ratio that systems will want. However, many systems prefer to have a ratio above 1.0, even as high as 2.0, to be able to pay any large bills that come in. The desired current ratio may also depend on the system’s billing cycle. Systems that bill bi-monthly, quarterly, or less frequently will want a ratio high enough to pay all monthly bills until they have another infusion of cash from customers paying bills.
It should be noted that financial statements do not show an annual total or even an annual daily average of cash, cash equivalents, receivables, or current liabilities. Rather, the numbers on financial statements represent the totals on the day the financial statements were prepared. That day may or may not have been representative. Perhaps the system just received a large influx of checks from customers to cover monthly bills, so the cash number could be higher than average. Conversely, it is possible that a large expense like an energy bill has just arrived, so the current liabilities may be higher than average. Staff who work regularly with system financials should be consulted to understand whether the reported unrestricted cash number is close to typical.
In our workshops on rate setting and fiscal planning for small water systems, we often include a session on how to measure key financial indicators like days of cash on hand by showing two example water systems—Bavaria and Mayberry. These are two similarly sized water systems from the same state (the names have been changed, but the numbers are real). Each serves about 1,500 customers, and each community has a median household income of about $30,000 with about 25 percent of residents living below the poverty line. On paper, these two systems look identical, but their days of cash on hand tell a very different story.
In our example, Bavaria has about $635,000 in unrestricted cash, cash equivalents, and receivables, with about $900,000 in current liabilities, giving it a current ratio of 0.71. In Mayberry, the unrestricted cash, cash equivalents, and receivables total about $150,000, whilst the current liabilities are about $108,000, giving it a current ratio of 1.38.
Mayberry’s current ratio exceeds the minimum 1.0 standard and gives the system some extra cash. However, Bavaria’s ratio fails to meet the minimum standard, meaning on the day the financial statements were prepared, Bavaria had more bills to pay than money with which to pay them.
In our previous posts, you may remember that Bavaria’s operating ratio, debt service coverage ratio, and days of cash on hand were all stronger than those of Mayberry, so seeing a current ratio for Bavaria below 1.0 is at first glance confusing. But it is important to remember that current ratio represents a snapshot in time—what was the ratio on the day that the financial statements were prepared, which may or may not be a “typical” day.
In the case of Bavaria, it was in fact not a typical day, and the notes to the financial statements provided the explanation of why. Bavaria had earned a subsidy of $460,000 from its state for a capital project. In this particular state, the state reimburses the system for the cost of the capital project after work has been completed. On the day the financial statements were prepared, the system had not yet received its $460,000 subsidy from the state but did have the companion $460,000 bill in its current liabilities. If you were to include the subsidy in Bavaria’s available cash, its current ratio goes from 0.71, below the minimum standard, to 1.22, above the standard.
Both Bavaria, when corrected, and Mayberry meet the minimum standard for current ratio, but neither is close to the 2.0 level that many systems prefer. Are their current ratios high enough? That is up to the individual water and wastewater systems to determine, and a rate increase can help increase the ratio. Taken with other financial ratios, current ratio can help systems understand their financial decision as they make choices about their rates for the coming year.