Liquidity Ratio

What is Liquidity Ratio?

Liquidity ratios are accounting indicators of a company’s capacity to meet short-term obligations. Prospective creditors and lenders frequently use liquidity ratios to determine whether or not to extend credit to businesses. These ratios compare the amount of current liabilities reported on an organization’s most recent balance sheet to various combinations of reasonably liquid assets. The higher the ratio, the more likely a company will be able to meet its obligations on schedule. The liquidity ratio has an impact on the company’s credibility as well as its credit rating. If a short-term liability is not paid on time, it will result in bankruptcy. As a result, this ratio is critical to a company’s financial stability and credit ratings.

A major drawback of employing liquidity ratios is that a company’s current liabilities may not be due on the same dates that the offsetting current assets can be liquidated. Thus even a strong liquidity ratio can hide a cash shortfall. Another issue is that these ratios ignore a company’s ability to borrow money. A large line of credit might compensate for a low liquidity ratio.

What is Liquidity in a Business?

The ability of a company to pay down its short-term liabilities—those due in less than a year—is measured by liquidity. It’s commonly expressed as a ratio or proportion of the company’s debts to its assets. These indicators can provide insight into the company’s financial health. The more liquid an asset is, the easier it is to convert it to cash. Assets are used by businesses to run their operations, make goods, and create value in various ways. An asset must have an established market with multiple interested buyers in order to be considered liquid. The asset must also be able to readily and swiftly transfer ownership.

Importance of Liquidity Ratios

• Investors and creditors use liquidity measures to judge whether and to what extent a company can meet its short-term obligations. A ratio of one is preferable to one less than one. Higher liquidity ratios are preferred by creditors and investors. A higher ratio proves that the company will be in a better position to meet its short-term liabilities. Moreover, analysts prefer a liquidity ratio more than 1. A ratio of less than 1 indicates a negative working capital situation and the possibility of a liquidity crisis.
• Liquidity ratios are used by creditors to determine whether or not to issue credit to a company. They want to know that the company they’re lending to will be able to repay them. A company’s capacity to secure loans may be harmed by any sign of financial instability.
• For investors, liquidity ratios will be used to determine whether a company is financially sound and worthy of their investment. Working capital constraints will also affect the rest of the company. A business must be able to pay its short-term debts with considerable flexibility.
• Liquidity ratios strike a balance between a company’s ability to pay its debts safely and incorrect capital allocation. The assets must be deployed in the most efficient way possible to improve the firm’s value for shareholders.

Types of Liquidity Ratios

1. Current Ratio
2. Quick Ratio
3. Cash Ratio

Current Ratio

The current ratio is a direct comparison of a company’s current assets and liabilities.

Current assets that are either cash or such assets that can be converted to cash in a year or less. Moreover, current liabilities are obligations that will be due for payment paid in a year or less. 

In order to understand a company’s ability to cover short-term debt with current assets investors prefer analysing the current ratio. Moreover, this ratio for a specific company is then compared with competitors within the industry. The current ratio has several flaws, including the difficulties of comparing it across industries, the overgeneralisation of individual asset and debt balances, and the lack of trending data.

Formula

Current Ratio = Current Assets / Current Liabilities

Quick Ratio

The quick ratio measures a company’s ability to fulfill current obligations without selling assets or borrowing money. The quick ratio is more cautious than the current ratio, which recognizes all current assets as current liability coverage.

Only the most liquid assets available to fund short-term debts and commitments are considered in the quick ratio. Liquid assets are ones that can be converted into cash quickly and readily in order to pay bills.

The higher the ratio, the better the company’s liquidity and financial health. Furthermore, the lower the ratio, the more likely it is that the company will have trouble paying its debts. 

Formula

Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities

Cash Ratio

The cash ratio extends the liquidity test even further. Only a company’s most liquid assets — cash and marketable securities – are considered in this ratio. They are the assets that a firm can use to satisfy short-term commitments the quickest. This is because while other current assets would need some time to be converted to cash, readily available cash and bank balance will fund the liabilities immediately.   

Cash Ratio = (Cash and Cash Equivalents + Marketable Securities) / Current Liabilities

Check out our article on What is Liquidity Trap?

Liquidity Ratio vs Solvency Ratio

Both solvency and liquidity are critical for a company’s financial health and ability to meet its obligations. Liquidity refers to a company’s ability to pay short-term bills and debts as well as its ability to quickly sell assets to raise cash.

The ability of a company to meet long-term debts and continue operating in the future is referred to as “solvency.” Solvency of a company is measured by analysing ratios such as debt asset ratio, interest coverage ratio, and debt equity ratio. 

How to Increase Liquidity in a Company? 

• Pay Debts in Time – Liquidity ratios examine assets and debt with a maturity date of less than a year. The liquidity ratios will improve as the companies pay down debt.
• Reduce Overhead Costs – Overhead costs do not generate revenue for the company directly. Hence, known as overhead such as wages, rent, office supplies, insurance, and bank or legal fees.  Examining the overhead expenses can provide unexpected cost savings leading to a decrease in current liabilities.
• Lower Debt Collection Cycle – Current assets include a debt receivable from sales to customers. A company must aim at decreasing its debt turnover ratio by lowering the number of days it takes to collect its receivables. A company can adopt few practices such as periodic collection targets, gentle reminders, discounts on early or advance payments, no delay in issuance of invoices. 
• Lower Accounts Payable – Similar to accounts receivable, accounts payable to creditors have a direct and huge impact on liquidity. A company must take advantage of discounts, industry practices, negotiate terms, and so on to lower its accounts payable. 

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