What Are Liquidity Ratios

A liquidity ratio is a financial ratio used to analyze a company’s capacity to satisfy its short-term debt commitments. It helps determine whether a company can pay its current liabilities using its liquid assets. Commonly utilized capital ratios are the current quick and cash ratios. In the equations’ denominator and numerator, we place the current liabilities and liquid assets amounts in each liquidity ratio.

Liquidity is the ease or efficiency with which a company may obtain cash to pay bills and other short-term commitments. Highly liquid assets include the ones you can quickly sell, such as stocks and bonds (although cash is the most liquid asset). Businesses require adequate cash to satisfy their expenses and commitments to pay suppliers, maintain up-to-date payroll, and continue day-to-day operations. 

All liquidity ratios calculate a company’s capacity to pay short-term commitments by dividing current assets by liabilities. For example, the cash ratio simply considers cash divided by current liabilities. But the quick ratio includes cash equivalents, marketable securities, and accounts receivable.

Types of Liquidity Ratios

• Current Ratio

The current liquidity ratio assesses a company’s capacity to pay its commitments within a year or less. It explains to investors and analysts how a corporation might optimize its balance-sheet current assets to satisfy its current and other liabilities. 

Using the current ratio, one can assess a company’s ability to repay its current liabilities (liabilities and accounts payable) with its existing assets, namely cash, inventory, and receivables. Analysts determine this ratio by comparing a company’s assets to liabilities.

Cash, accounts receivable, inventory, and other current assets (OCA) are assets on a company’s balance sheet that are expected to be liquidated or converted to money soon. In fewer than a year, accounts payable, wages, taxes owed, current obligations, and the present part of long-term debt are all current liabilities.

We calculate the current ratio by dividing existing assets by current liabilities.

Current Ratio = Current Assets / Current Liabilities 

• Quick Ratio

The quick ratio assesses a company’s capacity to satisfy its short-term commitments using its most liquid assets and indicates its short-term liquidity situation.

It is also known as the test ratio acid since it demonstrates the company’s capacity to rapidly deploy cash-like assets (assets that an organization can swiftly convert to cash) to pay down short-term liabilities.

The total liquidity ratio assesses a company’s capacity to pay existing creditors without selling inventory or obtaining additional financing. Therefore, we see it as a more cautious metric than the current rate. Because the current rate considers all current assets as a buffer against current obligations.

Quick Ratio = Current Assets – Inventory / Current Liabilities

• Cash Ratio

The cash ratio assesses a company’s liquidity. It explicitly computes the ratio of a company’s total cash and cash equivalents to its current liabilities. An index that assesses a company’s capacity to pay short-term debt in cash or near-cash, such as easily tradable securities. 

Creditors can use this information to determine how much money they can lend to a firm. Because it strictly refers to cash or its equivalents, the cash ratio is often a more conservative perspective of a company’s capacity to fulfill its debts and commitments than other liquidity measures. In place of other assets, such as accounts receivable, we use cash. The cash ratio formula for a corporation is as follows:

Cash Ratio = Cash + Cash Equivalents / Short-Term Liabilities

Importance of Liquidity Ratios for Organizations

Investors and creditors can assess a company’s ability to meet its short-term obligations and to what extent using liquidity ratios. Although a liquidity ratio of one is considered an acceptable benchmark, it is generally more favorable for a company to have a ratio greater than one.

Investors and creditors favor higher liquidity ratios, like two or above. A corporation is more likely to be able to cover its short-term expenses with a higher balance. If the ratio is less than one, the company may have a liquidity problem and negative working capital if the ratio is less than one.

Investors use liquidity metrics to assess a company’s financial stability and value. Working capital restrictions will also impact the rest of the company. A company needs a lot of leeway to pay its short-term obligations.

Low liquidity ratios are concerning, but the proverb “the greater, the better better” is partially true. Investors will ponder the high liquidity ratios of a company. A company with a liquidity ratio of 6 or more will be able to make short-term payments confidently, but the balance is excessive. A high ratio shows the company has a sizable amount of liquid assets.

The ratio paints a complete picture of how the business is run. It demonstrates the company’s ability to sell its goods and services effectively and profitably while turning inventory into cash. This ratio can help a company improve its production system and plan better inventory storage to reduce loss or control overhead costs.

High vs. Low Liquidity

Ratios above one are preferable given the ratio’s structure, with assets at the top and liabilities at the bottom. A ratio of one implies that the company’s current assets are adequate to meet all current liabilities. 

The corporation can only satisfy its present obligations if the ratio equals one. The corporation can only fulfill its present commitments if the ratio equals one. A 4.0 ratio indicates that management can cover the company’s debts four times its current obligations.

Liquidity vs. Solvency Ratios

Solvency ratios evaluate a company’s ability to meet all its financial obligations and long-term debts rather than its liquidity ratio. Liquidity is primarily concerned with current or short-term financial accounts, whereas “solvency” refers to a company’s ability to pay debts and maintain operations.

A company needs more assets than total liabilities to be solvent, and a corporation requires more current assets than current liabilities. Therefore, liquidity ratios give an early indication of a company’s solvency even though they are not directly related.

In Conclusion

A crucial component of financial analysis that should always be considered is the analysis of liquidity ratios. Measuring an organization’s profitability, efficiency, and return is very illuminating. Liquidity is converting an asset into cash quickly and without losing money.