Take a quick glance at Wal-Mart Stores' (NYSE:WMT) financials and you would be forgiven for thinking that the company is in trouble. In particular, it would appear that at first glance, Wal-Mart is unable to cover all of its current liabilities falling due within 12 months with current assets.
Why is this important? Well, if a company's current assets are less than its current liabilities, then it may run into trouble as it might not be able to pay back creditors in the short term. Current assets and current liabilities are defined as assets and liabilities falling due within 12 months. This part of the balance sheet usually includes things such as bank overdrafts, invoices, expenses, and cash.
What's more, an analysis of Wal-Mart's quick ratio appears even more troubling. The quick ratio is more indicative of current liquidity than the current ratio because it excludes inventories from current assets. Inventories generally take time to be converted into cash. If they must be converted into cash quickly, the company may have to accept a lower price than book value for these inventories.
Unfortunately, Wal-Mart has a quick ratio of 0.2, which means that excluding inventories, Wal-Mart only has $0.20 for every $1 in liabilities falling due within 12 months.
In some cases, this would be a bad thing and investors would be advised to stay away from Wal-Mart. Usually a company that cannot meet short-term creditor demands could be facing an imminent threat of bankruptcy.
Nonetheless, financial ratios tend to be sector-specific. Effectively, this means that while debt ratios, valuations, or liquidity ratios may seem odd for one company, they must be compared to sector peers in order to gain a suitable comparison.
Indeed, certain businesses traditionally have a very low quick ratio, and the retail sector is one of them. Companies leading the retail sector are able to negotiate favorable credit terms with suppliers due to their dominance over the market.
But if we dig into the numbers, we are able to establish a better picture of what is really going on. In the case of Costco, based on fiscal third-quarter numbers, the company's inventory was worth slightly less than $7.9 billion. Meanwhile, accounts payable on the liabilities side of the balance sheet were booked at a similar figure. This implies that Costco is leveraging its size to only pay suppliers when it wants to and not when its suppliers deliver the goods. If we strip out accounts receivable and inventories, Costco is easily able to cover current liabilities with cash on hand.
Target exercises the same kind of leverage over its suppliers. In particular, at the end of the fiscal third quarter, the company reported that it had inventory to the value of $8.4 billion and accounts payable of $7.1 billion.
However, Target's financial situation is slightly more pressing that Costco's, as the company has $1.9 billion of debt maturing within the next 12 months. Unfortunately, the company only has $1 billion in cash to cover this liability, but with a Morningstar credit rating of A, Target should easily be able to roll this debt to a longer maturity.
Unsurprisingly, Wal-Mart's low quick ratio is also a result of supplier leverage. Specifically, at the end of the fiscal third quarter the company had $49.6 billion in inventory booked on its balance sheet; accounts payable totaled $39.2 billion for the period. Short-term debt amounted to $12.8 billio,n but I feel silly to suggest that Wal-Mart, as one of the world's largest corporations, would have trouble paying that back or refinancing.
So all in all, a low quick ratio is fairly standard within the retail industry and investors have no need to be concerned about Wal-Mart's low level of working capital. Actually, this is helpful to know when examining the retail sector in general: a low quick ratio is not always a bad thing.
Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.