As promised in my last blog post, Today I will share my knowledge of another type of ratio used in a company’s assessment of meeting debt obligations. The Liquidity Ratio.
Liquidity ratios are an important class of financial metrics used to determine a company’s ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company’s ability to pay debt obligations and its margin of safety through the calculation of metrics including the Current ratio, Quick ratio, and Operating cash flow.
- Liquidity ratios are an important class of financial metrics used to determine a debtor’s ability to pay off current debt obligations without raising external capital.
- Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding.
- Liquidity ratios determine a company’s ability to cover short-term obligations and cash flows, while solvency ratios are concerned with a longer-term ability to pay ongoing debts.
Types of Liquidity Ratios
- Current Ratio:
The current ratio measures a company’s ability to pay off its current liabilities (payable within one year) with its total current assets such as cash, account receivables, and Inventories. The higher the ratio, the better the company’s liquidity position:
- Quick Ratio:
The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets. It is also known as the acid-test ratio.
Difference between solvency and Liquidity Ratio:
In contrast to liquidity ratios, solvency ratios measure a company’s ability to meet its total financial obligations and long-term debts. Solvency relates to a company’s overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current or short-term financial accounts.
A company must have more total assets than total liabilities to be solvent; a company must have more current assets than current liabilities to be liquid. Although solvency does not relate directly to liquidity, liquidity ratios present a preliminary expectation regarding a company’s solvency.
The solvency ratio is calculated by dividing a company’s net income and depreciation by its short-term and long-term liabilities. This indicates whether a company’s net income can cover its total liabilities. Generally, a company with a higher solvency ratio is considered to be a more favorable investment.
Why is liquidity an important factor to a firm?
Liquidity refers to how easily or efficiently cash can be obtained to pay bills and other short-term obligations. Assets that can be readily sold, like stocks, fixed deposits, investments and bonds, are also considered to be liquid (although cash is, of course, the most liquid asset of all). Businesses need enough liquidity on hand to cover their bills and obligations so that they can pay vendors, keep up with payroll, and keep their operations going day in and day out.
In my next blog, I will share my key learnings on another type of ratio “The Efficiency Ratio”