How to Calculate Liquidity Ratio? - Ultimate Guide
While making money is attractive for every business owner, the final profit you have on hand is what pays the bills at the end of the day. Do you monitor your company's liquidity ratios as a business owner? If not, it would be helpful if you would do so.
The mere fact that your firm holds money in the bank accounts doesn't qualify your business as liquid. It is also about the correlations between all of your current assets and liabilities.
In this article, you will find out what liquidity is, what liquidity ratio represents, what the most common types of ratios are, and why they are so important.
First, let's find out what liquidity is.
What Is Liquidity?
In the world of finance, liquidity describes the simplicity of how to exchange a particular asset or security without having an impact on its pricing. When an asset has a high level of liquidity, it can be quickly and effectively sold for estimated returns or market price. When there are no opportunities to purchase and sell, exchanging such assets is challenging, which means their liquidity is low.
Considering cash to be one of the most liquid financial assets, liquidity can also refer to how quickly an asset can be converted into cash.
Now, let's take a closer look at three main types of liquidity:
A) Asset liquidity: As already mentioned, the ease with which an asset can be purchased or sold and converted into cash is referred to as its liquidity. Because cash can be sold seamlessly without affecting its market value, it has the highest liquidity of any asset. Similarly, bonds or stocks are likewise regarded as highly liquid investments. However, the liquidity of each will fluctuate according to the actual stock's demand. On the other hand, real estate and fine art are perfect examples of illiquid assets because, despite being highly valued, they can be more challenging to sell.
B) Market liquidity: Liquidity on a particular financial market describes the current condition where a specific asset is to be purchased or sold. There is high liquidity when there are many buyers and sellers on the market, as buying or selling your asset at the rate you prefer is simpler. On the other hand, illiquid markets are those kinds of markets where there are fewer market participants. Say you want to trade on the market focused on expensive collectibles or any other rare market. It makes it more difficult to sell assets at the price you want since there are not enough participants. Also, stock markets are likely to lose liquidity during a financial crisis.
C) Accounting liquidity: Accounting liquidity describes how well a business can settle financial commitments, such as securities, cash, inventories, and receivables. Accounting liquidity provides information about a company's financial stability, which is frequently monitored by investors.
Now, with a clearer image of liquidity and its main varieties, let's look at what the liquidity ratio illustrates.
What Are Liquidity Ratios?
Certain assets can be converted into cash easily, such as shares of a particular company. However, converting other, less popular assets into cash is more complicated. Comprehending an asset's liquidity is essential for company owners who want to optimize their capital and profits but also want quick access to money if needed.
Using liquidity ratios, businesses can better comprehend and manage their assets, cash reserves, and liabilities. Therefore, it is vital to know how to calculate these ratios and incorporate them into your investment strategy.
The liquidity ratio is also used to measure a borrower's capacity to settle existing debt commitments without needing extra financing. The measurement of indicators such as the current ratio, quick ratio, and cash ratio allows individuals to calculate liquidity ratios, which evaluate a company's capacity to meet debt obligations as well as its safety margin.
Liquidity ratios can be most effectively measured using a comparative format. Both so-called internal and external analyses may be used to calculate it correctly.
For instance, employing numerous accounting intervals that are recorded using the same financial statements is necessary for the internal study of liquidity ratios. Analysts can follow improvements in the firm by evaluating historical periods to ongoing activities. A higher liquidity ratio, overall, indicates that a business is more liquid and has decent coverage of its existing loans.
In contrast, an external report examines several businesses', or even an entire sector's, liquidity ratios. Comparing the firm's operations stance to its competition is helpful when setting benchmark targets. Since firms demand various financing formats, liquidity ratio research may not be as beneficial when comparing different businesses. Liquidity ratio analyses are not so effective when used to measure enterprises of different sizes and interests.
Also, note that liquidity ratios assess a company's capacity to meet short-term commitments in a crisis by comparing current liabilities to liquid assets.
Now, if the theory is clearer, let's take a closer look at the main categories of liquidity ratios and how to calculate them.
The capacity of a business to fulfill its short-term obligations within one year is evaluated using the current ratio (sometimes known as the working capital ratio.) This indicator demonstrates how a business can use its current assets to the fullest to pay its short-term debts.
Calculating a firm's existing (or current) ratio shows whether it's a wise purchase. A business with a current ratio of less than 1 has insufficient capital to pay its short-term debts since its liabilities outweigh its current assets by a bigger margin.
In contrast, a business with a current ratio above 1 is more likely to pay off its current debts because it has no imminent liquidity issues. An abnormally high current ratio, say above 3, could mean that the business can cover its debts three times more. On the other hand, it can also indicate that the business isn't handling its finances well.
Current assets and liabilities are two components on a company's balance sheet used to determine the current ratio. Here is what the formula looks like:
Current Ratio = Current Assets / Current Liabilities
The outcome shows the number of times a corporation can use its current assets to satisfy its current short-term liabilities.
Simply put, dividing existing liabilities by current assets generates the current ratio. An increased ratio suggests greater liquidity.
Let's take a look at an example. Suppose a specific company has 100 000 USD in total current assets and 75 000 USD in total current liabilities. Thus, 100k/75k equals 1.33 times.
First, you must contrast this information with the ratio from the preceding year. It also relies on the sector of business you are in.
Also, the result of substantial inventories, the current assets will be 4 or 5 times the current liabilities, which could be the case with food or clothing businesses.
Another type is the quick ratio. This measure was designed to directly assess a business's ability to pay short-term obligations with its most liquid assets. When a corporation has a high quick ratio, it can pay its bills in a short period of time and yet have enough liquid assets left behind.
A quick ratio of 1 is regarded as the industry standard. It indicates to interested parties that the business is not making enough money to cover its current obligations. A quick ratio of less than 1 means a company may not have enough liquid assets to pay its present liabilities.
On the other hand, a company with a quick ratio above 1 has enough liquid assets that can be converted into cash to pay its financial liabilities. It basically means that the business has more liquid assets than current liabilities.
The quick ratio is defined by dividing the whole of a firm's liquid assets by its current liabilities. The basic formula is as follows:
Quick Ratio = (Quick Assets – Inventory – Prepaid Expenses) / Current Liabilities
The business can rapidly transform liquid assets into cash to pay off an expiring debt. Thus, the quick ratio is crucial since it determines a company's ability to survive in the short term. The quick ratio can evaluate a company's financial condition and performance.
Example: Consider there is 100 000 USD in current assets.
The remainder is inventory consisting of 80 000 USD in liquid assets. The obligation remains at 75 000 USD.
The quick ratio would be 80 000 / 75 000, or 1.06. As a result, the company's liquid assets can be used to pay for liabilities at any time.
We must examine this data from the prior year to determine whether the company's creditworthiness has improved.
A quick ratio over 1 usually is sufficient. Still, one or less is often viewed as inadequate as it implies the company won't be able to meet short-term obligations unless they sell some of the inventory and turn the earnings into cash.
The cash ratio evaluates a company's current liabilities against its most liquid assets. This ratio measures a company's ability to meet short-term obligations or, more specifically, if it has enough liquidity to continue operating. Since it does not contain inventories (compared to the current ratio) and receivable accounts, it is considered among experts the most conservative of all main liquidity measurements. This ratio may be too conservative, especially if receivables are readily exchangeable into cash within a short period.
To calculate this ratio, you must divide current liabilities by the sum of cash and cash equivalents. Since accumulated costs might not need to be paid for immediately, excluding them from the existing liabilities in the denominator of the calculation may result in a somewhat more realistic vision of the situation. The formula helping to calculate the cash ratio is as follows:
Cash Ratio = Cash & Equivalents / Short-Term Liabilities
In this case, let's take a look at an example from the real world:
Apple had $26.8 billion in marketable securities and $37.1 billion in cash at the end of 2021. The tech giant had $63.9 billion in cash to pay its short-term obligations immediately. The company was liable for approximately $123.5 billion in current commitments, including accounts payable and other liabilities.
$63.9 million / $123.5 billion equal 0.52 in terms of the short-term ratio.
Apple's organizational structure demonstrates how it leverages debt, benefits from advantageous credit conditions, and focuses on cash for business expansion. The corporation has billions of dollars on hand, but it has almost twice as many short-term liabilities.
Now, when you are more familiar with the formulas and types of ratios, it is time to move on to the final part to determine why these ratios are important.
Why Are Liquidity Ratios Important?
1) Evaluating your capacity for fulfilling essential responsibilities
Lenders and investors use liquidity measures to assess a company's ability to pay short-term commitments and to what extent. Despite not being ideal, a ratio of 1 is better than one that is less than 1.
Creditors and investors tend to prefer higher liquidity ratios, like 2 or 3. A specific corporation is more likely to be able to pay its short-term debts if the ratio is higher. If the ratio is less than 1, the business may be amid a liquidity crisis and have negative operational capital.
2) Establishing credibility
Liquidity ratios are taken into consideration by creditors when determining whether or not to grant a business credit. They need to make sure that the company they lend money to will be able to repay them. Any indication of financial uncertainty may prevent a business from receiving financing.
3) Determining investment sustainability
Investors use liquidity ratios to evaluate businesses and determine whether they are financially sustainable and if they "deserve" their money. Therefore, a company must be able to fulfill its short-term obligations.
Low liquidity ratios are concerning, although the cliche "the higher, the better" is not always true. Investors may, at some point, wonder why a company's ratios are so high. A business with a ratio of, say, more than 8 will undoubtedly be able to meet its short-term obligations. Such a ratio, however, may seem strange to investors. An extraordinarily high ratio indicates the company has a lot of liquid assets.
Analysts and investors might think that if a company's cash ratio is high, that particular firm has an excessive amount of cash, and the firm is only generating the interest the bank gives to store the company's cash. Investors may conclude that the company is not investing in further expansion or developing new services or products.
Remember that with liquidity ratios, it is vital to find a middle way between a company's ability to pay its debts on time and excessive capital allocation. The optimum use of capital should maximize the firm's value for shareholders.
You can use various liquidity ratios for assessing a company's liquidity, although the current, quick, and cash flow ratios are the most popular ones. These ratios can provide you with a complete image of how a particular company is doing financially.
It is necessary for businesses to have cash on hand to cover their expenses. A company's ability to satisfy short-term obligations is measured by its liquidity ratios, which are essential to its financial health. Moreover, they are highly beneficial for examining the financial status of businesses operating in the same field.