The liquidity ratio tells about a business’s ability to pay off its debts. A liquidity ratio greater than 1 is a good ratio, which shows the good financial health of the company.
The higher the liquidity ratio the higher will be the margin of safety. This ratio is used by creditors and lenders to know how much time to delay the credit.
What this article covers:
- What are the types of Liquidity Ratios?
- How to calculate Liquidity Ratio?
- What is an example of a Liquidity ratio?
- Why Are there Several Liquidity Ratios?
- What are the liquidity ratios used for?
- What Happens if Ratios Show a Firm Is not Liquid?
What are the types of Liquidity Ratios?
There are many ratios used in general for the analysis of liquid assets to short-term liabilities. The ratios mostly used are three:
- Current Ratio
- Acid test or Quick Ratio
- Cash Ratio
These ratios assess the ability of a business to keep up with short-term debts.
How to calculate Liquidity Ratio?
The current ratio is also known as the working capital ratio, it shows the ability of a business to pay its current liabilities with current assets.
Current Ratio = Current Assets
We take an example of having total current assets of $600,000 and total current liabilities of $300,000; the current ratio will be 2:1.
A higher current ratio is a good ratio, such as between 1.2 to 2. The above example shows that the business’s current assets can cover 2 times more of current liabilities.
The current assets are liquid assets that can be easily converted into cash within one year, such as cash, cash equivalent, accounts receivable, short-term deposits, and marketable securities. The current liabilities are considered short-term debts that are payable within a year.
A current ratio below 1 means that the company doesn’t have enough liquid assets to cover its short-term liabilities. A ratio of 1:1 indicates that current assets are equal to current liabilities and that the business is just able to cover all of its short-term obligations.
Acid test ratio:
The acid test ratio also known as a quick ratio, is used to determine how a business could pay off its current liabilities with quick assets. Quick assets are the current assets that are convertible into cash within 90 days. It excludes supplies, inventory, and prepaid expenses.
Acid Test Ratio = (Cash and Cash Equivalents + Current Receivables + Short-Term Investments) / Current Liabilities
If the balance sheet does provide a breakdown of the current assets, you can calculate the acid test ratio using the formula:
Acid Test Ratio = (Total Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
The acid test ratio should not be less than one. If it happens, then it means the business does not have the ability to pay off its debts. Compare the two ratios, current and acid test ratios, and if there is a large difference between them, then it means that the business is using a large amount of inventory.
The cash ratio is also known as the cash-asset ratio. The ratio of cash and cash is equivalent to its total liabilities. This ratio is mostly used by creditors and lenders to determine how much cash or cash equivalents are readily available to pay off their current debts.
Current Ratio = (Cash + Cash equivalent) / Current Liabilities
If the cash ratio is less than 1, the company does not have enough cash available to pay off its short-term debt. When the cash ratio is equal to 1, the business has the exact amount of cash or cash equivalent to pay its liability. The cash ratio of a company greater than 1 shows that the business has the ability to pay its liabilities along with the remaining cash. But the remaining cash also indicates that the company is not investing in profitable investments properly.
What is an example of a Liquidity Ratio?
|Cash and Cash Equivalent
|Other Current Assets
|Total Current Assets
|Total Current Liabilities
1. Current Ratio = Total Current Assets / Total Current Liabilities
Current Ratio = 8700 / 5700 = 1.53
2. Acid Test Ratio = (Total Current Assets – Stock) / Current Liabilities
Acid Test Ratio = 8700 – 4000 / 5700 = 0.83
3. Current Ratio = (Cash + Cash Equivalent) / Current Liabilities
Current Ratio = 3000 / 57000 = 0.53
The liquidity ratio has an impact on the credit rating as well as the credibility of the business. The more liquid your business is, the better equipped it is to pay off short-term debts.
On the other hand, if there are continuous defaults in repayment of a short-term liability, it can lead to bankruptcy. Hence, this ratio plays important role in assessing the health and financial stability of the business.
Why Are there Several Liquidity Ratios?
Fundamentally, all liquidity ratios measure a firm’s ability to cover short-term obligations by dividing current assets by current liabilities (CL). The cash ratio looks at only the cash on hand divided by CL, while the quick ratio adds in cash equivalents (like money market holdings) as well as marketable securities and accounts receivable. The current ratio includes all current assets. Thus, the different ratios differ in how conservative they are: While it is relatively easy to sell stocks, it may take a day or two to clear. Cash, however, is already available to pay bills.
What are the liquidity ratios used for?
Analysts use liquidity ratios to gauge the financial health of a company. Higher liquidity ratios imply that there is little risk of default on debts. They also provide a glimpse into what actions the company might need to take over the next several months if they don’t have enough cash.
If a company doesn’t have enough working capital, it might be forced to sell assets, take on debt, or issue more shares of equity. Any of those actions could be adverse to an investor. Taking on debt or selling assets implies a shareholder equity reduction (assets minus liabilities). Likewise, issuing additional shares results in stock dilution, reducing the value of current interests.
What Happens if Ratios Show a Firm Is not Liquid?
In this case, a liquidity crisis can arise even at healthy companies if circumstances arise that make it difficult to meet short-term obligations, such as repaying their loans and paying their employees or suppliers. One example of a far-reaching liquidity crisis from recent history is the global credit crunch of 2007-09, where many companies found themselves unable to secure short-term financing to pay their immediate obligations. The company may be forced to liquidate assets in a fire sale or seek bankruptcy protection if new financing cannot be found.
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