What’s it: The liquidity ratio is a financial ratio to measure a company’s ability to meet its short-term obligations. Commonly used ratios are the current ratio, cash ratio, and quick ratio. Their calculations are relatively easy because we only need arithmetic operations. In addition, accounts for calculating them are also available in current assets and current liabilities on the balance sheet.
Why is the liquidity ratio important?
The liquidity ratio is a metric to measure the company’s financial health. It tells how well the company can meet its short-term obligations. We then measure it using several ratios.
The company’s short-term liabilities are presented in current liabilities. It shows several accounts such as accounts payable, accrued liabilities, and short-term payables. Companies must settle them all within the next 12 months or within one accounting period.
How capable is the company of doing it? We then compare it to the account in current assets. For example, a company can pay for it with cash on hand or by withdrawing a short-term investment. Another way is to collect receivables from customers to obtain cash. Or the company converts inventory into sales and cash. And then use the money to pay obligations.
However, not all accounts in current assets are liquid. Cash and short-term investments are the most liquid because companies can immediately use them to pay suppliers. Instead, they will need more days to convert inventory and accounts receivable.
What are some examples of liquidity ratios and formulas for calculating them?
Three ratios are commonly used to measure a company’s liquidity:
- Cash ratio
- Quick ratio
- Current ratio
We calculate them by comparing the components in current assets with current liabilities. As the numerator, we use the total current assets or several accounts in it, considering how liquid they are. Meanwhile, as the denominator, we use current liabilities.
The company uses its cash to pay its liabilities. It is the most liquid because companies can use it at any time and for anything. The next liquid assets are cash equivalents.
If both are insufficient, the company must convert some current assets such as accounts receivable and inventory into cash. But, if we compare them to cash and cash equivalents, they are less liquid because they cannot be converted quickly into cash with little or no loss of value.
In addition to the three ratios above, two other indicators to measure company liquidity are:
- Defensive interval ratio
- Cash conversion cycle
The first describes how enough the company’s most liquid assets can cover routine daily expenses. Meanwhile, the second measures how long it takes the company to convert money into the inventory, sell it and then collect cash from customers.
The cash ratio is the tightest liquidity ratio because it only takes into account the most liquid assets. It is an essential metric to measure how well a company’s liquidity position is to deal with stressful conditions. To calculate it, we add up the cash and cash equivalents. Then, we divide it by current liabilities. Here is the cash ratio formula:
- Cash ratio = Cash and cash equivalents / Current liabilities
A higher cash ratio indicates better liquidity. This is because the company has sufficient cash to pay its current liabilities. The opposite conclusion applies when it is lower.
The quick ratio adds accounts receivable as the numerator of the cash ratio. Meanwhile, we still use current liabilities as the denominator. So, to calculate it, we add up cash and cash equivalents, short-term investments, and accounts receivable and then divide by current liabilities.
Accounts receivable represents money owed by customers. For example, the company sells goods or provides services to them but has not received cash payments at the time the financial statements are made. And the company hopes to collect it at a later date.
Accounts receivable are less liquid because it takes more days to collect them. In addition, some customers may have difficulty paying; thus, it could lead to bad debts.
- Quick ratio = (Cash and cash equivalents + Short term investment + Accounts receivable) / Current liabilities
Like the cash ratio, a higher quick ratio is more desirable because it indicates a better liquidity position. A ratio above one means the company should have less problems with liquidity. Conversely, a lower ratio indicates the opposite condition.
The current ratio is the loosest metric than the previous two. We calculate it by dividing current assets by current liabilities.
- Current ratio = Current assets / Current liabilities
As with the previous two ratios, a higher ratio indicates sufficient current assets to pay short-term liabilities. A ratio equal to 1 is usually the limit. If it is lower, it could signal a liquidity problem.
As a note, we must use this ratio with caution because not all current assets contribute to future cash inflows.
Take, for example, prepaid expenses. The company records it as a current asset because it flows economic benefits to the company in the future. However, it doesn’t always bring in cash inflows.
Prepaid expenses arise when a company has paid suppliers for goods to be delivered in the future. If it is for the purchase of raw materials, the company must convert them first. Then, the company sells them and collects payments. But, if it is not raw materials, it does not bring in cash at all, but only economic benefits.
Furthermore, the current ratio also contains an inventory account, which is less liquid than cash and cash equivalents, short-term investments, and accounts receivable.
Inventory takes more days to turn into cash. First, the company has to sell it. However, it doesn’t always generate cash because it could just be accounts receivable. Then, the company needs a few more days to collect the receivables.
Defensive interval ratio
The defensive interval ratio relates the company’s liquid assets to its daily expenses. First, we calculate it by adding up cash, short-term investments, and accounts receivable. Then, we divide it by the daily cash outlay.
- Defensive interval ratio = (Cash + Short-term investments + Accounts receivable) / Daily cash outlays
This ratio shows how much money the company has to cover daily expenses. A higher ratio is preferred. That’s because it shows the company is able to pay daily expenses and bills without relying on external financing such as borrowing from a bank.
Cash conversion cycle
The cash conversion cycle measures how many days it takes to spend money to buy the inventory to collect cash back. The company converts cash into inventory. Then, they sell the product, collect payments from customers and pay suppliers. The cash conversion cycle formula is as follows:
- Cash conversion cycle = DOH + DSO – DPO
- Days sales outstanding (DSO) shows how many days, on average, the company collects payments from customers.
- Days of inventory on hand (DOH) tells how many days, on average, a company converts inventory into sales.
- Days payable outstanding (DPO) measures the average number of days a company pays its suppliers.
To calculate all three, we use the following formula:
- DOH = 365 / Inventory turnover = (Average inventory * 365) / Cost of goods sold
- DSO = 365 / Accounts receivable turnover = (Average accounts receivable * 365) / Revenue
- DPO = 365 / Accounts payable turnover = (Average accounts payable * 365) / Purchases
- Purchases = Ending inventory + Cost of goods sold – Beginning inventory
Shorter cycles are more desirable because the company makes money faster from its operations. Thus, it indicates a liquid business operation. On the other hand, a longer cycle indicates poorer liquidity because the company needs more days to make money.
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