A liquidity ratio offers information concerning a company’s stability and liquid circumstances.
You can assess a company’s ability to quickly pay off debt using this financial metric.
In this blog post, you’ll discover more about the various ratios, how to work them out, and the ideal values.
What is a liquidity ratio?
A liquidity ratio is a financial metric that reveals whether a firm has sufficient capacity to pay off its short-term debt responsibilities.
Working capital derives from existing possessions – particularly cash and cash equivalents (like marketable securities that can be sold to generate revenue). The easiest way to work out a firm’s liquidity ratio is to divide its existing assets by its existing liabilities.
There are three main types of liquidity ratios: the current ratio, quick ratio, and cash ratio.
For every liquidity ratio, the current liabilities sum is positioned in the denominator of the equation, while the amount of the liquid assets are positioned in the numerator.
Due to the ratio’s structure (assets sitting at the top and liabilities at the bottom), any ratio over 1.0 is sought after. If a company’s ratio is one, this means it can pay off its current liabilities with its existing assets. Anything lower than one – for example, 0.75 – suggests the firm cannot meet its current liabilities.
On the other hand, if the ratio is over one (say 2.0), this indicates the firm can pay off double its current fees. If it’s 3.0, this suggests it may pay off triple the amount of its current liabilities, and so on.
Three commonplace liquidity ratios
1. Current ratio
Working out the current ratio of a company or person is the easiest and most popular method of calculating liquidity.
The current ratio takes into account the firm’s entire current assets, like available funds and so forth, alongside its full current liabilities, such as its outstanding debt.
You can work this out using the following formula:
Current Ratio = Current Assets / Current Liabilities
2. Quick ratio
Otherwise known as the acid test ratio, the quick ratio considers whether you can pay off your debt with quick assets – assets you can convert to cash within a 90-day timeframe.
Thus, the quick ratio is an excellent indicator of short-term liquidity. Use the below formula when working this out:
Quick Ratio = (Cash + Marketable securities + Accounts receivable) / Current liabilities
3. Cash ratio
Lastly, there’s the cash ratio, which examines whether or not your firm can pay off its current liabilities using cash or cash equivalents such as treasury bills or marketable securities, and so on.
You don’t need to include other assets such as inventory, prepaid expenses, and accounts receivable in your calculation.
Use the following liquidity ratio formula to ascertain your firm’s cash ratio:
Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities
These aren’t the only liquidity ratio formulas you can use. There’s an operating cash flow ratio, too, but for the most part, you just need to get to grips with the current, quick, and cash liquidity ratios.
Ways to use liquidity ratios
Liquidity ratios can divulge a lot about an organisation. Let’s look at what it can reveal:
Several start-ups may encounter high debt during the early months of launching, but a longstanding, well-established company must generate enough income to survive.
When a firm can’t manage a stable cash flow throughout its existence, it probably isn’t created for profitability.
Fundamentally, liquidity ratios are solvency ratios. When a firm doesn’t have adequate liquid assets to settle short-term obligations and debt fast, it could come close to becoming insolvent.
Several firms find it challenging to have a reasonable amount of cash within reach, as their clients fail to pay their debts punctually.
The Days Sales Outstanding (DSO) ratio is another type of liquidity ratio that evaluates how much revenue a company generates in one day with the profit of accounts receivable.
While accounts receivable don’t count towards all liquidity ratios, it’s certainly a critical element of the quick ratio, preferred by some investment bankers and finance leaders.
Need a hand? Get professional advice
If you need more guidance on liquidity ratios, speak to one of our expert accountants – we’re here to help.