What are liquidity ratios? Well, let’s start with liquidity. Put simply, liquidity is the ability to convert an asset into cash. In terms of a business, it refers to the general amount of liquidity the business has. In other words, the amount of cash and/or assets that can be easily converted to cash that a business has available to it.
Accounts receivables and inventory are great examples of liquid assets. When a balance sheet has more liquid assets (or current assets) than current liabilities (i.e., payments that the company will need to make in the short-term), it shows the company has enough liquidity to meet its short-term obligations.
However, there’s a better way to gauge a company’s liquidity—with liquidity ratios.
What are liquidity ratios exactly?
Liquidity ratios represent a company’s relative access to liquid assets, and in turn, its ability to pay short-term obligations without external financing.
Financial analysts and investors commonly use liquidity ratios to gauge a company’s ability to pay its creditors and lenders.
Before you use liquidity ratios, there’s something you should know—more liquidity isn’t always better. When a company has too much money tied up in liquid assets, it will lose out on earning higher returns on relatively less liquid assets. Ideally, a company should hit the sweet spot between having too much and not having enough.
For instance, you’d never want to see more current liabilities than current assets on your balance sheet because that means you don’t have enough liquidity. On the other hand, if your current assets are 10x the current liabilities, you’re not investing money optimally.
Now that you know what liquidity ratios tell you and have a basic idea of how you should interpret them, let’s look at the three types of liquidity ratios.
Types of liquidity ratios
Each liquidity ratio tries to analyze the company’s liquidity, but with varying levels of conservatism. The current ratio is the least conservative, while the cash ratio is the most conservative. Let’s talk about how.
1. Current ratio
The current ratio simply compares current assets to current liabilities. It tells if you have enough liquidity to meet your short-term obligations. The formula, quite intuitively, is:
Current Ratio = Current Assets ÷ Current Liabilities
A current ratio of less than 1 can spell trouble, but there’s no optimum ratio, because the optimum current ratio differs based on the industry.
Current Asset Definition: current assets are assets that are expected to be converted to cash or used up within one year, or one business cycle.
Current Assets Definition: current assets are assets that are expected to be converted to cash or used up within one year, or one business cycle.
Current Liabilities Definition: current liabilities are liabilities that are expected to be due within one year, or one business cycle.great way to learn more Want to learn some more great accounting / finance terms? Check out our list of key accounting vocabulary here.
2. Quick ratio
The quick ratio is also called the acid-test ratio because it tests a company’s liquidity more stringently than the current ratio. Unlike the current ratio, the quick ratio doesn’t include all current assets. It only includes current assets that can be quickly converted into cash.
For instance, inventory is excluded because even though it’s a current asset, you may or may not be able to liquidate it quickly.
The formula for quick ratio is:
Quick Ratio = [Cash & Cash equivalents + Accounts Receivable + Marketable Securities] ÷ Current Liabilities
Cash Equivalents Definition: cash equivalents are assets that are not at risk of significantly changing in value that can be converted to cash immediately. Examples include commercial paper, Treasury bills, and some short term government bonds.
3. Cash ratio
The cash ratio is the most stringent of all the three liquidity ratios. It only includes cash and cash equivalents in the numerator and tells you whether you’re holding enough cash and marketable securities to meet short-term obligations.
The cash ratio can be calculated using the formula:
Cash Ratio = [Cash + Cash Equivalents] ÷ Current Liabilities
How do you calculate liquidity ratios?
Liquidity ratios are what are known as balance sheet ratios. That is, ratios whose data is pulled from the balance sheet. So how do you calculate them? It’s simple, just pull the info described above straight off of the balance sheet. (Want to learn more about balance sheets? Check out our great introduction to balance sheets here.)
Importance of liquidity ratios
Liquidity ratios allow companies and stakeholders to monitor liquidity.If a company becomes illiquid, it can be at significant risk of not being able to satisfy its upcoming obligations. (Not to mention any surprise obligations.) It may also experience higher borrowing costs as lenders may charge a higher interest rate because they perceive the company as a higher risk borrower.
The ratios can also be useful in rooting out the causes of poor liquidity. For instance, if a company’s current ratio is poor, but it has a good quick ratio, the problem probably has something to do with inventory. If you’ve started holding too much inventory, it will adversely impact your current ratio, but not the quick and cash ratios.
However, context is important too. A company may need more inventory because they expect greater demand for their product or because they’re introducing a new product line.
Limitations of liquidity ratios
Liquidity ratios help analysts, investors, and lenders understand a company’s liquidity position. They do come with a few inherent limitations, though:
- Liquidity ratios are calculated based on historical figures,i.e., the book value of current assets. The value of marketable securities can often change quickly and can impact a company’s liquidity position.
- It’s possible that a fundamentally strong company is going through a brief rough patch. Such circumstances aren’t reflected in a liquidity ratio and may create unnecessary concern.
- Liquidity ratios are calculated the same way for all industries. This is a problem because different industries require different levels of liquidity. Some industries are cyclical, while others have significantly higher working capital requirements.
Even with their limitations, liquidity ratios provide valuable insight into a company’s liquidity position. They’re reliable tools as long as you’re mindful of their limitations and understand how to use them.
Now that you’re a master of liquidity ratios maybe it’s time for some more intermediate accounting concepts. Check out our post introducing contra accounts, or our primer on the difference between cash flows and profits to keep pushing your accounting knowledge to even greater heights.
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