What is the liquidity ratio?
A business needs funds in order to meet its commitments. A liquidity ratio indicates the ability of an organization to the stakeholders as and when it comes due. In general, liquidity ratios measure liquidity and these ratios are short-term in nature. If an organization is unable to fulfill its commitment, it adversely impacts its credibility and credit rating. Further, this can result in closure or bankruptcy. Hence, understanding liquidity ratios is crucial.
What do liquidity ratios measure?
Liquidity ratios measure the ability of a company to meet its debt obligations and its margin of safety through the calculation of metrics including operating cash flow ratio, quick ratio, and the current ratio.
Insufficient and excess liquidity is not good for an organization. A liquidity ratio greater than 1 indicates that the company is in good financial health and is less likely to face any hardships. A higher ratio indicates that the business is equipped to meet its current liabilities. It also indicates how quickly a company can convert its assets into cash to pay off its liabilities on a timely basis.
- Liquidity ratios are an important metric that is a measure of the ability of a company to meet its debt obligations
- Liquidity ratios are a result of diving liquid assets by current liabilities and short term borrowings
- The higher the liquidity ratios are the higher is the ability of the company to meet its current liabilities.
Importance of liquidity ratios:
The purpose of liquidity ratios is to help one understand the financial position of a company. It also helps you to perceive the short-term financial position of the firm. A higher ratio implies that the company is stable while the poor ratio carries a risk of monetary damages.
The ratio provides a complete idea of the operating system of the concerned company. It depicts how efficiently and effectively the company sells its products and services to convert the inventories to cash. This ratio can help a company to improve its production system and to plan better inventory storage for avoiding any loss or managing any overhead expenses.
A company’s financial stability is also dependent on its management. Considering this ratio can help a company optimize its management efficiency. The management can work towards the betterment of its working capital requirements.
Types of Liquidity Ratios:
There are two main liquidity ratio types commonly used and have been explained below.
- Current Ratio: It is one of the most commonly employed ratios for measuring liquidity or short-term solvency of a firm. It is the ratio of current assets and liabilities and measures whether there are enough assets to pay the current debts with a margin of safety of potential losses.
- Quick Ratio/Acid Test Ratio: This ratio measures the relationship between the current liabilities and quick assets. It indicates whether there are enough readily convertible funds to pay off current debts. It is better than the current ratio and considers only cash and near-cash assets. It does not take inventories into account as they cannot be converted readily into cash.
- Absolute Liquidity Ratio: This ratio measures the total liquidity available for a company. It only considers cash and marketable securities to the company.
- Basic Defense Ratio: This ratio measures the number of days a company can cover its cash expenses without any need for additional financing from other sources.
How to calculate liquidity ratio?
If you are interested in liquidity ratio calculation, then you can either calculate the current ratio or quick ratio depending on what you are interested in learning about a company.
Current Ratio:The current ratio is estimated by dividing the current assets by current liabilities.
Current Ratio = Current assets / Current liabilities
Both variables can be obtained from the balance sheet of a company.
Quick Ratio:The quick ratio is estimated by dividing liquid assets by current liabilities.
Quick Ratio = (Current Assets - Inventories) / Current Liabilities
For calculating liquid assets, inventories have to be deducted as they are less liquid in comparison to all current assets. All these variables are shown on a balance sheet. Here is another more accurate formula for calculating the quick ratio.
Quick Ratio = (Cash & equivalents + Marketable securities + Accounts receivable) / Current Liabilities
This formula comprises the most liquid assets and high liquid assets in the numerator and hence tends to be more accurate while carrying out liquidity ratio analysis and interpretation.
Absolute Liquidity Ratio:This ratio pits cash, equivalents, and marketable securities against current liabilities. Businesses should always strive for achieving an absolute liquidity ratio of 0.5 or higher.
Absolute Liquidity Ratio = (Cash + Marketable securities) / Current Liabilities
Basic Defense Ratio:This accounting metric determines how many days a company can run on its cash expenses without any external financial aid.
Basic Defense Ratio = (Cash + Receivables + Marketable securities) / (Operating expenses + Interest + Taxes)
Liquidity ratio examples:
Let us consider two hypothetical companies X Inc. and Y Inc. with the following assets and liabilities on their balance sheets. Let us make an assumption that both companies are operating in the FMCG sector.
If X Inc.’s current assets amount to ₹40 million, inventories amount to ₹10 million, and current liabilities equal ₹80 million, cash and cash equivalent equals ₹15million, marketable securities equals ₹5million, then
Current Ratio = ₹40million / ₹80 million = 0.5
Quick Ratio = (₹40 million - ₹10 million) / ₹80 million = 0.375
Absolute Liquidity Ratio = (₹15million + ₹5million) ₹80million = 2.5
If Y Inc.’s current assets amount to ₹60 million, inventories amount to ₹30 million, and current liabilities equal ₹50 million, cash and cash equivalent equals ₹10million, marketable securities equals ₹7million, then then
Current Ratio = ₹60million / ₹50 million = 1.2
Quick Ratio = (₹60 million-₹30 million) / ₹50 million = 0.6
Absolute Liquidity Ratio = (₹10million + ₹7million) / ₹50million = 0.34
We can draw numerous conclusions based on the Current Ratio and Quick Ratio comparison of these two companies. Y Inc. has a high degree of liquidity as it has ₹1.2 of current assets for every dollar of its current liabilities. Its quick ratio indicates that it has adequate liquidity even after excluding inventories.
The liquidity ratio is a useful financial metric that helps in understanding the financial position of a company. It provides the stakeholders with a complete idea of the operating system of a company and also depicts how efficiently and effectively the company sells its products and services. The company management can also use the ratios to work towards the betterment of its working capital requirements.