Let’s deep dive into what is liquidity ratio. In this post, we elaborate on types of liquidity ratios, how to calculate it and examples. Let’s get started!
Liquidity ratio
The liquidity ratio defines one’s ability to pay off debt as and when it becomes due. In simpler terms, we can say that liquidity ratio is a company’s capability to turn current assets into cash quickly so that it can pay debts in a timely manner. The liquidity ratio is used to determine the credibility of a company. In this article, we will learn more about the liquidity ratio and how it’s calculated.
What are liquidity ratios?
Liquidity ratios are used to determine a company’s ability to pay off debt as and when required without requiring external capital. Some of the common liquidity ratios include quick ratio, current ratio, and operating cash flow ratios. Liquidity ratios can be defined as a company’s ability to fulfil short-term obligations and cash flows. The simplest way to calculate the liquidity ratio is by dividing a company’s current assets by its current liabilities.
What does the liquidity ratio measure in a company?
The liquidity ratio is an important financial metric for any business. Below we will discuss the three things measured by liquidity ratio in a company:
- Solvency
Liquidity ratios are essentially solvency ratios, meaning if a company does not meet the ideal liquidity ratio requirement, it may teeter on the edge of bankruptcy.
- Profitability
A well-established business must have a steady cash flow to remain profitable. The liquidity ratio determines if the company is making a profit or not.
- Efficiency
The liquidity ratio helps in determining how efficiently a company is able to convert inventories into cash and the way it operates in the market.
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Importance of liquidity ratio
Liquidity ratios are important to determine whether or not your company can pay off its debts. When a company’s liquidity ratio goes below 1:1, it means it needs to find ways to increase liquid assets. A creditor or an investor generally prefers working with a company with liquidity ratios closer to 2:1 or 3:1 because that means the company has enough funds to pay its short term debts and still have working capital left to continue operations. A lower ratio indicates a higher risk level. The company’s credit score is calculated based on its liquidity ratio.
Types of liquidity ratios
There are different types of liquidity ratios, out of which these three are fairly common ones – the current ratio, the quick ratio, and the cash ratio. Each of these liquidity ratios is measured by dividing a company’s liquid assets by its current liabilities amount. We will discuss each of them below.
Current liquidity ratio
The current ratio is the simplest liquidity ratio to measure the financial strength of a company. A ratio between 1.5 and 3 is considered to be ideal, but it usually depends on industry to industry. The formula to calculate the current ratio is:
Current liquidity ratio = current assets/ current liabilities
Quick liquidity ratio
The quick liquidity ratio calculation takes higher liquidity assets into account as compared to the current ratio. Generally, 1:1 is treated to be an ideal quick ratio. The formula to calculate quick ratios is:
Quick ratio = Quick Assets/ current liability
Quick assets = Current assets – Inventory – Prepaid expenses
Cash liquidity ratio
The cash liquidity ratio is said to be the strictest means of calculating a company’s liquidity. The cash liquidity ratio takes only the highest liquidity assets like cash and liquid stocks into account. The formula to calculate the cash liquidity ratio is:
Cash ratio = (Cash and cash equivalent)/ current liabilities
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Liquidity ratio formula
The basic rule to find a liquidity ratio is by putting current assets in the numerator and current liabilities in the denominator. However, the liquidity ratio formulas vary from one liquidity ratio type to another. Let us take a look at each one of them.
Current ratio = current assets / current liabilities
Quick ratio or acid test ratio = (current assets – inventory) / current liabilities
1:1 quick ratio represents an ideal financial position of a company
Cash ratio = cash and equivalent / current liabilities
Absolute liquidity ratio = (cash and equivalent + marketable securities) / current liabilities
Basic defense ratio = current assets / daily operational expenses
Steps in calculating liquidity ratios
There are several steps involved in calculating liquidity ratio based on which type of liquidity ratio you wish to calculate. Few steps that remain common for any kind of liquidity ratio calculation includes:
- Create a list of all the assets and liabilities with their respective amount.
- Calculate current liability and current asset values
Use following formulas to measure different liquidity ratios:
Current ratio = Current assets / Current liability
Quick ratio or acid-test ratio = Quick assets / Current liability
Cash ratio = Cash balance / Current liabilities
Absolute liquidity ratio = (cash and equivalent + marketable securities) / Current liabilities
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Liquidity ratios examples and real case studies
There are several liquidity ratios used to judge a company’s financial condition. Calculating the liquidity ratio would give a fair idea of a company’s short-term solvency. In the below section, we will take a look at liquidity ratio examples and related real-world case studies to understand them better.
Measurement of liquidity
Measurement of liquidity is an integral part of any company’s financial statement analysis. It demonstrates a company’s ability to overcome short-term financial obligations. To evaluate a company’s liquidity, company leaders can calculate the ratios based on information found on the company balance sheets.
A real-life example can be taken from a study conducted to measure the liquidity ratio of Rockwell during the time period 2013 – 2016. The average current ratio was found to be 2.69 indicating that the company was in good financial health and capable of paying off short-term financial debts that may occur.
Liquidity ratio examples
Let us take a look at an example of how to calculate different types of liquidity ratios:
A company has the following particulars:
Inventory : $200000
Cash: $50000
Sundry debtors: $300000
Bills receivable: $35000
Creditors: $250000
Bank overdraft: $50000
Current ratio = Current assets / Current liability
= (sundry debtors + inventories + cash + bills receivable) / (creditors + bank overdraft)
= (300000 + 200000 + 50000 + 35000) / (300000)
= 585000/300000
= 1.95 : 1
Quick ratio or acid-test ratio = Quick assets / Current liability
= (current assets – inventories) / current liability
= (585000 – 200000) / 300000
= 385000 / 300000
= 1.28 : 1
Cash ratio = Cash balance / Current liabilities
= 50000 / 300000
= 0.16 : 1
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Liquidity ratios analysis
Liquidity ratio analysis can be defined as the measurement of the short-term solvency of a company. Let us take a real-life example of two companies ABB and Rockwell.
Ratio analysis was calculated for both companies. As per the study, it was concluded that the average current ratio of ABB was 1.49 and Rockwell was 2.69 for the period 2013 – 2016. Less liquidity ratio of ABB suggested a liquidity crisis for the company in the short term. Likewise, the current ratio of Rockwell is more than 2 which indicates poor financial planning on part of the company.
Define liquidity indicators
There are three main indicators of liquidity – absolute liquidity, urgent liquidity, and current liquidity.
The absolute liquidity ratio is equal to the ratio of a total of cash and short-term financial investments to short-term liabilities.
The urgent liquidity ratio is equal to the ratio of highly liquid current assets (cash assets + short term financial investments + short-term accounts receivable) to current liabilities.
The current liquidity ratio is the financial ratio of current assets to current liabilities.
Define short term liquidity ratio
Short term liquidity ratio is a company’s ability to meet its short-term financial requirements without requiring external capital. Short term liquidity ratio generally measures the balance between a company’s current liabilities and current assets. Current liabilities can be in the form of trade creditors, VAT, bank overdrafts, etc. and current assets will be stocks, cash, etc. The key short term liquidity ratios are the current ratio and acid test ratio.
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Define asset liquidity ratio
Asset liquidity ratio helps a company determine if they can pay off their current liabilities as well as their future liabilities as they become current with the help of their current assets. The asset liquidity ratio not just measures how much cash a company has but also how quickly a company can raise cash or convert assets into cash when needed. All the assets go into the liquidity calculation of a company.
Define relative liquidity
Relative liquidity is metric that measures a company’s ability to pay near term expenses. The degree of relative liquidity is the same as the current ratio. Both of them measure a company’s ability to use cash flow or asset’s to satisfy short-term liabilities that may arise in near future. An organization with a lower degree of relative liquidity will have difficulty fulfilling its debt obligations in a timely manner. Companies with low relative liquidity might face long-term financial issues.
Define operating liquidity
Operating liquidity can be defined as the balance between current resources present in the form of cash or resources available to be readily converted into cash and current liabilities for which cash will be required in the upcoming days. Working capital and operating liquidity are extremely crucial for any business.
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Define statutory liquidity ratio
Statutory liquidity ratio is the minimum reserve requirement that must be maintained by commercial banks in the nation. Statutory liquidity ratio is mandatory and legally required. These assets can be in the form of gold, cash, or securities that are approved by the Indian government.
Megha is a content writer with sharp technical skills, owing to her past experience in networking and telecom domains. She focuses on various topics including productivity, remote work, people management, technology, market trends, and workspace collaboration.
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