Wilko’s Collapse: Understanding Quick Ratios

In the current economic climate, many businesses are struggling with increased costs from inflation and rising interest rates. British high street retailer Wilko has hit headlines as one of many who can no longer afford to continue trading.

Information published at the end of July by the UK Government’s Insolvency Service highlight that Wilko is not alone. After seasonal adjustment, the number of company insolvencies in the UK in Q2 2023 was the highest since Q2 2009 [source: GOV.UK].

The question is, could these insolvencies have been foreseen? Quick ratios are a useful accounting tool to flag potential financial distress.

What is a quick ratio?

Also known as the “acid test”, a quick ratio is an easy to calculate metric to evaluate whether a company can meet its current liabilities using its liquid assets.

The most common way to calculate the quick ratio is to sum a company’s cash and cash equivalents, and accounts receivable, and divide this by a company’s current liabilities.

Relative to other commonly used ratios, such as the current ratio (total current assets divided by total current liabilities), the quick ratio is a more conservative indicator as it excludes assets that are not readily liquidated, such as inventory.

Why does a quick ratio matter?

The quick ratio can be used to identify companies that might be in financial distress, providing useful information to auditors, investors, and lawyers alike. The rationale is simple - does a business have liquid assets sufficient to meet its upcoming obligations?

Whilst a healthy quick ratio varies by industry, a quick ratio of less than 1 is rarely a positive sign. The company will need to raise funds externally to meet upcoming liabilities and failure to do so risks default and potential insolvency.

Taking the example of Wilko and its most recently published accounts for the year to 29 January 2022 [source: GOV.UK], a calculation of Wilko’s quick ratio at the time would have revealed:

Wilko was your classic high street retailer, stocking everything from garden furniture to home accessories to decorating paint and wallpaper. Wilko didn’t seem to specialise in anything other than relatively low pricing. For Wilko – not a fast-growing business, nor one with access to equity injections or rapidly available external funding – a quick ratio of 0.40 meant it was running out of cash to pay off its liabilities with no realistic prospect of obtaining more.

A declining UK high street only added to the challenge faced by Wilko to turn its fortune around. Ernst & Young, Wilko’s auditors, also recognised the challenge they faced and noted in their 2022 audit report (released in November 2022) that there was a material uncertainty related to going concern. They explicitly stated that Wilko had “insufficient committed financing in place to withstand a severe but plausible downturn in trading activity” but, nevertheless, accepted that preparing Wilko’s accounts on a going concern basis was appropriate.

To be a going concern, a company must be expected to continue to trade and meet its obligations until the end of its going concern period. This period is twelve months from which the financial statements are issued. Looking at their calculated quick ratio of 0.4, it was apparent even then that Wilko was facing severe liquidity problems.

Sadly, no financial rescue came, and Wilko appointed administrators in August 2023, months short of the going concern period.

What are the issues with a quick ratio?

Whilst being a useful indicator, the quick ratio will not always tell the whole story. It looks at only one part of a company’s balance sheet and does not consider information from other parts of the financial statements. For example, the company may have a revolving credit facility which can be used to meet short term liabilities. Additionally, information outside of the financial statements may be relevant. For example, fast growing startups commonly burn through cash and are periodically funded through equity injections.

In summary, a low quick ratio is certainly a red flag and should be investigated, however it’s not necessarily the final say on the matter.