Liquidity Ratios Part 1

Liquidity Ratios Part 1

Liquidity ratio is type of financial ratio used to determine a company’s ability to pay its short-term debt obligations. This tool helps determine if a company can use its current, or liquid, assets to cover its current liabilities.

Three liquidity ratios are commonly used – the current ratio, quick ratio, and cash ratio. In each of the liquidity ratios, the current liabilities amount is placed in the denominator of the equation, and the liquid assets amount is placed in the numerator.

Given the structure of the ratio, with assets on top and liabilities on the bottom, ratios above 1.0 are seems okay. A ratio of 1 means that a company can exactly pay off all its current liabilities with its current assets. A ratio of less than 1 (e.g., 0.75) would imply that a company is not able to satisfy its current obligations.

A ratio greater than 1 (e.g., 2.0) would imply that a company is able to satisfy its current bills. In fact, a ratio of 2.0 means that a company can cover its current liabilities two times over. A ratio of 3.0 would mean they could cover their current liabilities three times over, and so forth.

Types of Liquidity Ratios

1. Current Ratio: This is the current Assets over the Current Liabilities.

Stating this mathematically:

Current Ratio = Current Assets / Current Liabilities

• Quick Ratio: This considers more current assets such as cash, accounts receivables, and marketable securities.

Stating this mathematically:

Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities

• Cash Ratio: This considers a company’s most liquid assets – cash and Market Securities.

Stating this mathematically:

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

Importance of Liquidity Ratios

1. Determine the ability to cover short-term obligations

Liquidity ratios are important to investors and creditors to determine if a company can cover their short-term obligations, and to what degree. A ratio of 1 is better than a ratio of less than 1, but it isn’t ideal.

Creditors and investors like to see higher liquidity ratios, such as 2 or 3. The higher the ratio is, the more likely a company is able to pay its short-term bills. A ratio of less than 1 means the company faces a negative working capital and can be experiencing a liquidity crisis.

• Determine creditworthiness

Creditors analyse liquidity ratios when deciding whether or not they should extend credit to a company. They want to be sure that the company they lend to has the ability to pay them back. Any hint of financial instability may disqualify a company from obtaining loans.

• Determine investment worthiness

For investors, they will analyse a company using liquidity ratios to ensure that a company is financially healthy and worthy of their investment. Working capital issues will put restraints on the rest of the business as well. A company needs to be able to pay its short-term bills with some leeway.

Here are examples of how two companies applied liquidity ratios.

A company that produces and sells plantain starch to the pharmaceutical industry wants to ensure it has enough liquidity to meets its current obligation. The company’s management team decides to focus on improving its Current Ratio, which is currently at 0.90. The company decided to sell some capital assets that are not generating a return to the business. After selling of these assets, the company’s current ratio improved to 2.0. This means that the company is able to cover twice it’s current liabilities.

Another company that produces and sells motor parts wants to increase its liquidity ratio. The company’s management team decides to focus on improving its Quick Ratio, which is currently at 0.50. The team decides on the reduction of its collection period from 60 days to 30 days. The company decided to incorporate this in the payment terms for goods sold to debtors. After implementing this change, this improved the company’s cash position and the Quick ratio also improved to 1.5. This mean that the company is 1.5 times able to pay off it’s current liabilities.