The Quick Ratio And Its Significance To Tesla

Last update on May 28, 2018.

Image Credit: Jan Faukner / Shutterstock.com

 

Tesla is the most entertaining finance reality show around. On the one hand, you have its CEO Elon Musk claiming he’ll completely revolutionize the auto industry. On the other hand, you have famous hedge fund managers who are comparing the company to Enron.

Lately, the conversation has centered around whether the company could go bankrupt this year. Moody’s, which holds the reputation as the best credit rating agency, downgraded Tesla’s debt rating to B3 earlier this year, signalling that there’s a significant risk that Tesla will indeed go bankrupt. But Elon Musk himself ridiculed the idea, through a now infamous April Fool’s joke.

Many amateur investors are therefore understandably confused, wondering whether Tesla really is in danger of bankruptcy or not. So I thought this would be the perfect opportunity to explain what the ‘quick ratio’ is, so as to help such investors make sense of Tesla’s current situation.

Let’s first talk about a related concept called the “current ratio”. By definition, the current ratio is the current assets divided by current liabilities. “Current assets” are assets that are either cash, or can be turned into cash within a year. “Current liabilities” are the opposite - they are obligations that the company needs to pay off within a year.

As you might imagine, you generally want a company’s current assets to exceed current liabilities. Otherwise, it means your cash needs exceed your cash resources. Investors therefore pay attention to the size of current assets relative to current liabilities, which is what current ratio is, and become nervous if that ratio dips below 1 (i.e. current liabilities exceed current assets).

The problem with the current ratio, however, is that some current assets may not be worth the value stated on the company’s financial reports. This is most often the case with inventories, which include fully and partially finished products that haven’t been sold yet.

Accountants generally calculate the inventories number as the amount of money the company has spent on building the product. There’s no guarantee the company will recoup this amount through sales, particularly if the company goes bankrupt. Think about it - how much would people pay for Tesla’s vehicles if the company went bankrupt?

Investors therefore use something called the “quick ratio” to get a more conservative view of a company’s financial health. Quick ratio is by definition the ratio of current assets less inventories, divided by current liabilities.

For Tesla in particular, the ratio doesn’t paint an encouraging picture. As of the end of March 2018, Tesla’s quick ratio stood at just 0.44, meaning that the company probably doesn’t have the cash resources to meet all its obligations.

Sometimes, the quick ratio paints an overly gloomy picture of a company, which becomes apparent when you dig into the details. But unfortunately, that’s not the case for Tesla.

On the asset side, Tesla has some $2.7 billion in cash and $650 million in receivables (money they expect to receive from customers). But aside from the $2.6 billion in inventories, they have another $380 million tied up as “prepaid expenses and other current assets”. Like inventories, this item may not be worth as much as they’ve stated depending on the nature of the “other current assets”.

The liabilities side, on the other hand, includes $2.6 billion in accounts payable (money Tesla owes to suppliers), $985 million in customer deposits (a large portion of which are refundable), $1.9 billion worth of long term debt that’s due within a year, $1.9 billion in “accrued liabilities and other” (which includes expected warranty costs), $536 million in “resale value guarantees” (amount committed for buying back older vehicles), and $629 million in deferred revenues (cash collected on product that hasn’t shipped yet).

If Tesla is lucky, the company’s accrued liabilities and resale value guarantees won’t turn out to be as burdensome as they’re reported on their financial statement. But even if we exclude those obligations completely, Tesla’s quick ratio would still be far from exceeding 1.0.

Now, that doesn’t necessarily spell doom for Tesla. If the company raises money, its cash could jump and the quick ratio could soar to above 1.0. But even if it doesn’t raise cash, the quick ratio could improve over time if the company turns a consistent profit. Lastly, the quick ratio might be painting an overly pessimistic view if it doesn’t take into account the fact that the company could borrow money anytime it wants.

But there are problems with all of these points. Elon Musk has stated that he doesn’t want to raise money this year. Tesla has never turned a profit for more than one quarter in a row, and realistic financial projections make it doubtful that it’ll profit anytime soon. Lastly, the company has been increasing its borrowings, and it may soon run out of options to borrow more.

All of this makes Tesla an intriguing story to follow. Will the company blindside investors by suddenly announcing it’s bankrupt? I personally don’t think that’ll happen (I think they’ll raise money despite what Musk says), but it’s no longer unthinkable.

Disclosure: I own put options on Tesla.

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