What It Measures
Liquidity ratios are a set of ratios or figures that measure a company’s ability to pay off its short-term debt obligations. This is done by measuring a company’s liquid assets (including those that might easily be converted into cash) against its short-term liabilities.
There are a number of different liquidity ratios, which each measure slightly different types of assets when calculating the ratio. More conservative measures will exclude assets that need to be converted into cash.
Why It Is Important
In general, the greater the coverage of liquid assets to short-term liabilities, the more likely it is that a business will be able to pay debts as they become due while still funding ongoing operations. On the other hand, a company with a low liquidity ratio might have difficulty meeting obligations while funding vital ongoing business operations.
Liquidity ratios are sometimes requested by banks when they are evaluating a loan application. If you take out a loan, the lender may require you to maintain a certain minimum liquidity ratio, as part of the loan agreement. For that reason, steps to improve your liquidity ratios are sometimes necessary.
How It Works in Practice
There are three fundamental liquidity ratios that can provide insight into short-term liquidity: current, quick, and cash ratios. These work as follows:
This is a way of testing liquidity by deriving the proportion of assets available to cover current liabilities, as follows:
Current ratio = Current assets ÷ Current liabilities
Current ratio is widely discussed in the financial world, and it is easy to understand. However, it can be misleading because the chances of a company ever needing to liquidate all its assets to meet liabilities are very slim indeed. It is often more useful to consider a company as a going concern, in which case you need to understand the time it takes to convert assets into cash, as well as the current ratio.
The current ratio should be at least between 1.5 and 2, although some investors would argue that the figure should be above 2, particularly if a high proportion of assets are stock. A ratio of less than 1 (that is, where the current liabilities exceed the current assets) could mean that you are unable to meet debts as they fall due, in which case you are insolvent. A high current ratio could indicate that too much money is tied up in current assets—for example, giving customers too much credit.
This indicates liquidity by measuring the amount of cash, cash equivalents, and invested funds that are available to meet current short-term liabilities. It is calculated by using the following formula:
Cash ratio = (Cash + Cash equivalents + Invested funds) ÷ Current liabilities
The cash ratio is a more conservative measure of liquidity than the current ratio, because it only looks at assets that are already liquid, ignoring assets such as receivables or inventory.
The third liquidity ratio is a more sophisticated alternative to the current ratio, which measures the most liquid current assets—excluding inventory but including accounts receivable and certain investments.
Quick ratio = (Cash equivalents + Short-term investments + Accounts receivable) ÷ Current liabilities
The quick ratio should be around 0.7–1, with very few companies having a cash ratio of over 1. To be absolutely safe, the quick ratio should be at least 1, which indicates that quick assets exceed current liabilities. If the current ratio is rising and the quick ratio is static, this suggests a potential stockholding problem.
Tricks of the Trade
All of these ratios have advantages and disadvantages. It is important to remember that any ratio that includes accounts receivable assumes a liquidation of accounts receivable—this may not be possible, practical, or desirable in many situations.
Liquidity ratios should therefore be considered alongside ratios demonstrating the time it would take to convert assets to cash—a conversion time of several months compared to a few days would seriously affect liquidity.
Some analysts use a fourth liquidity ratio to measure business performance, known as the “defensive interval.” This measures how long a business can survive without cash coming in—and ideally should be between 30 and 90 days.