Liquidity Ratios

What are Liquidity Ratios?

Liquidity is a company's ability to quickly convert assets into cash and meet short-term obligations. Liquidity ratios are used to measure the financial capability of the company. 

Liquidity ratios assess an organisation's capacity to fulfil short-term obligations by establishing a systematic relationship between its current or liquid assets and current or short-term liabilities. These ratios offer insight into a company’s liquidity and assist investors and analysts in evaluating its ability to settle debts and finance daily operations by analysing financial statements through ratio analysis. A higher ratio indicates that an organisation can more easily meet its short-term obligations.

Types of Liquidity Ratios

Current Ratio

The current ratio assesses a company's capacity to pay its short-term liabilities, due within a year, using its current assets like cash, accounts receivable, and inventory. A higher ratio indicates a more excellent and stronger liquidity position.

Current Ratio= Current Assets / Current Liabilities

Current Assets = Stock, debtor, cash and bank, receivables, loan and advances, and other current assets.

Current Liability = Creditor, short-term loan, bank overdraft, outstanding expenses, and other liabilities.

Basic Defence Ratio

This ratio indicates the number of days a company can cover its cash expenses without needing additional financing from external sources.

Basic Defence Ratio = Current Assets/Daily Operational Expenses

Current Assets = Marketable Securities + Cash and Equivalent + Receivables

Daily Operational Expenses = (Annual Operational Costs – Non-cash Expenses)/365

Quick Ratio/Acid Test Ratio

The quick ratio, also known as the acid-test ratio, evaluates a company's ability to meet short-term obligations using its most liquid assets, excluding inventories from its current assets.​

Quick ratio= C + MS + AR/ CL

Where:

C = cash & cash equivalents

MS = marketable securities

AR = accounts receivable

CL = current liabilities

Or,

Quick ratio (Current assets - inventory - prepaid expenses) / Current liabilities

Cash Ratio 

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

The cash ratio elevates liquidity assessment by considering only the most liquid assets—cash and marketable securities—the most readily available for paying short-term obligations. Regarding strictness, the current, quick, and cash ratios can be seen as easy, medium, and hard liquidity tests, respectively.

Net Working Capital 

Net working capital (NWC) is calculated as current operating assets (excluding cash and equivalents) minus current operating liabilities (excluding debt and similar instruments). NWC shows whether a company has cash tied up in its operations or enough cash to meet short-term needs.

  • Positive NWC means more cash is tied up in operations, resulting in less free cash flow.
  • Negative NWC means less cash is tied up in operations, resulting in more free cash flow.

Liquidly, a negative NWC is preferred over a positive NWC.

Basic Liquidity Ratio 

Unlike the previously mentioned ratios, the primary liquidity ratio doesn't pertain to a company's financial status. Instead, it measures an individual's ability to support their family's needs using liquid assets. Ideally, a minimum of three months of financial backup is recommended.

Basic Liquidity Ratio = Monetary Assets / Monthly Expenses

Importance of Liquidity Ratios

There are a few reasons why liquidity ratios are significant for you:

  • Lenders consider the liquidity ratio a crucial parameter when offering loans to a company. Creditors and investors prefer higher liquidity ratios, typically around 2 or 3, indicating a company's ability to pay its short-term bills. A ratio below 1 suggests negative working capital and potential liquidity issues.
  • Assists in evaluating a company's financial health and solvency by determining its ability to meet short-term obligations.
  • Aids in assessing a company's risk profile.
  • When an organisation can't meet its short-term obligations, its credibility and credit rating suffer. Therefore, understanding an organisation's liquidity through liquidity ratios is crucial.
  • This can also lead to bankruptcy or closure. Both excess and insufficient liquidity are detrimental to the organisation.
  • Investors use liquidity ratios to assess a company's financial health and investment potential. Issues with working capital can impact the entire business. A company must be able to pay its short-term bills with some buffer.

Final Takeaways

Liquidity ratios are simple but powerful financial metrics that reveal a company's ability to meet its short-term obligations. Adequate liquidity is essential for smooth operations, allowing companies to cover expenses on time. These ratios offer valuable insights into a company’s short-term financial strength, risk profile, and cash management capabilities, helping you make informed investment decisions.

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