All about liquidity ratios and how to interpret them

Liquidity refers to a company’s ability to quickly and inexpensively convert its assets into cash. Debtors and lenders try to determine this ability using several liquidity ratios. This helps them determine the company’s health, credibility and creditworthiness.  

Read on to understand the meaning of liquidity ratio, formula, types, and calculations.  

What are liquidity ratios? 

Liquidity ratios determine a debtor’s ability to pay off short-term debt obligations without external funding. It measures the debt and margin of safety. This measurement is done through three different metrics — quick ratio, current ratio, and cash ratio.  

However, it is important to understand that liquidity ratios are seldom considered in silos. They are usually compared with those of other firms in the same industry. This is called internal analysis.  

Sometimes, debtors also conduct an external analysis. This involves comparing the company’s liquidity ratios with a different industry or a company within another industry. This information could be useful when the debtors are trying to analyse the company’s strategic positioning compared to its competitors.  

What are the types of liquidity ratios?  

Current Ratio 

The Current Ratio measures the firm’s ability to pay the current liabilities using its current assets. Liabilities due within a year are called current liabilities. Current assets are expected to be consumed by business operations within a year. It is calculated using the following formula:  

Current Ratio = Current Assets / Current Liabilities 

A higher current ratio is a good sign of a company’s debt situation. For instance, a current ratio of 1 means a company has enough current assets to cover its current liabilities. A ratio greater than 1 indicates that the company has more current assets than current liabilities, which is considered a good sign of liquidity. A ratio less than 1 indicates that the company has more liabilities than current assets, and may struggle to meet its short-term obligations. 

Quick Ratio 

The Quick Ratio is also called the acid-test ratio. It measures a firm’s ability to meet its obligations using its most liquid assets. So, while the current ratio includes all current assets, the quick ratio excludes some assets, such as inventories.  

Quick Ratio = (Cash and cash equivalents + marketable securities + account receivables) / Current liabilities

Another formula for the calculation of Quick Ratio is as follows:  

Quick Ratio = (Current ratio − inventory − prepaid expenses) / current liabilities

Cash Ratio 

It measures the company’s ability to cover its short-term obligations using only its cash and cash equivalents. This is a rather accurate measure since earnings can be manipulated.  

Operating Cash Flow Ratio = Operating cash flow / Current liabilities

Besides these ratios, some debtors could also consider the days’ sales outstanding (DSO). It refers to the days a company takes to collect payment from a sale. A high DSO shows the company is taking too long to collect payments, which could tie up its capital.  

Let's understand the calculation of liquidity ratios with an example: 

A company’s assets and liabilities are as follows: 

Cash: Rs 50,000 

Accounts receivables: Rs 20,000 

Inventory: Rs 30,000  

Total current assets: Rs 100,000 

Accounts payable: Rs 20,000 

Short-term loans: Rs 10,000 

Taxes owed: Rs 5,000 

Total current liabilities: Rs 35,000 

To calculate the current ratio, we’ll use the following formula:  

Current Ratio = Current Assets / Current Liabilities 

So, 

Current Ratio = Rs 100,000 / Rs 35,000 = 2.86

This company’s current ratio is 2.86, meaning it has 2.86 times more current assets than current liabilities. This is a sign that the company’s liquidity condition is good — it can meet its short-term obligations and pay off its debt quite comfortably. 

Importance of liquidity ratios 

A company’s liquidity ratio is important in determining its credibility and creditworthiness. A company that consistently fails to meet its short-term debt obligations could end up in bankruptcy. Therefore, this ratio is crucial in assessing the overall financial stability of the company and its credit ratings. 

Conclusion 

Liquidity ratios are vital tools for debtors and lenders in assessing a company’s ability to quickly and inexpensively convert its assets into cash. They can provide insight into the overall financial stability of a company and its credit ratings. Overall, companies must understand and monitor their liquidity ratios to meet their short-term debt obligations and avoid potential bankruptcy.

FAQs 

Q. How does solvency differ from liquidity? 

The Solvency Ratio measures a company’s ability to meet its debt obligations in the long term. In contrast, liquidity ratio looks at the short term. Solvency is the company’s ability to pay off its obligations and continue operations.  

Q. What happens if a firm is not liquid per its liquidity ratios?  

If a company is not liquid enough, its ability to pay off its short-term debt obligations could suffer. This could result in a liquidity crisis for the company. Even the healthiest of firms can face a liquidity crisis. In such a situation, the firm usually issues commercial paper (CP), a short-term debt instrument, to finance its current liabilities.