Liquidity Ratios (Definition, and List of Five Importance Ratios)

Definition:

Liquidity Ratios are the group of Financial Ratios normally used for analyzing and measuring the entity’s liquidity position by concerning the relationship between current assets and current liabilities.

The group of these ratios is the Current Ratio, Quick Ratio, Cash Ratio, Working Capital Ratio, and Time Interest-Earning Ratio. The liquidity Ratio normally focuses on the group of ratios that measure how the company’s assets could handle its current liabilities.

Management needs to control the liquidity problem in the entity. Otherwise, the entity will face a cash flow problem and less reliance on major suppliers and customers, as most take these ratios seriously.

We will discuss this in detail below.

Explanation:

Assume management approaches its major suppliers to extend the credit period. In this case, the suppliers may obtain the Current Financial Statements and perform an assessment and check if it is possible to provide a credit extension or not.

In most cases, liquidity ratios are among the most important ratios assessed by those suppliers.

Once the supplier noted the company probably faces a cash flow problem as the result of assessing the liquidity ratios, the suppliers probably feel uncertain about extending.

In addition, these ratios are also important from investors, bankers, and customers’ points of view. The reason is if the company cannot solve the liquidity problem, the company will subsequently face operational problems, as a result, there will be a lack of materials or other resources that is core to its operation.

Then, the company will face liquidation problems. And, subsequently, investors and banks will consider if it is okay to invest more. Big customers are also concerned about how long the company could play as their big supplier.

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However, there are some disadvantages to using a Liquidity Ratio. For example, by using only the liquidity ratio to assess the company’s liquidity problem, the analysis’s result seems unrealistic because those ratios are the result of financial figure calculation which could be manipulated by management.

The better way to make an analysis is to include these groups of ratios with other financial and non-financial ratios.

List of Most Used Liquidity Ratio:

Many ratios are normally used to analyze the company’s liquidity problem. However, the following are the most used Liquidity Ratio:

Current Ratio:

The most popular Liquidity Ratio that we normally see in any liquidity assessment and measurement. The current ratio is calculated by Current Assets/Current Liabilities.

The Current Ratio measures how the company’s current assets which normally include Inventories, Receivable, Cash, and Cash Equivalents would cover Current Liabilities.

The Current Ratio is said to be good if it is better than one. And if it is less than one, current liabilities are bigger than current assets. The company may find it hard to pay current liabilities by using its current assets.

Quick Ratio:

Quick Ratio is the most popular liquidity ratio we normally see in most assessments. This ratio measures the entity’s most liquid assets (Cash and Cash Equivalents)  over its current liabilities.

This ratio disregards inventories in its calculation because inventories need a bit long time to convert into cash.

If this ratio gets more than once, the entity’s current liquidity position is quite good as it has enough cash or cash equivalence to pay its high liquid liabilities.

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The calculation of this ratio is simple. We eliminate the inventories from current assets and divide them with current liabilities.

Noted: Quick ratio is also called acid-test ratio.

Cash Ratio:

Cash Ratio is another liquidity ratio that considers only cash, cash equivalent, and investment fund in the calculation and assessment.

This ratio is calculated by : (Cash + cash equivalent + investment fund)/Current Liability.

The common meaning of this ratio is to measure how the company’s cash equivalent could repay its current liabilities. The cash ratio is very similar to the Quick Ratio.

Working Capital Ratio:

This ratio is concerning about Current Assets and Current Liabilities. Working Capital Ratio is calculated in the same way as Current Ratios.

The main function of this ratio is to assess whether current assets could cover current liabilities or not. Increasing current assets leads to an increased working capital ratio, which is healthy when the ratio is higher than one.

Times Interest Earned Ratio:

Time Interest-Earning Ratio is also the Liquidity Ratio used to assess and measure whether the entity’s profit before interest and tax could cover its current interest expenses or interest charge. Sometimes we use interest expenses or sometimes we use interest charges.

These two are the same thing. The company generates enough profit to cover its interest charge if this ratio gets more than one.

Yet, if this ratio is smaller than one, the company might need to find other funds to pay its interest.

Why is it so important to calculate liquidity ratios?

There are many reasons why the liquidity ratios are calculated and assessed. The entity might want to assess its own liquidity ratios to ensure that it is not gonged to be rated down due to poor liquidity ratios by creditors, bankers, shareholders, and other related stakeholders.

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These ratios are also reviewed by the entity’s board of directors as their performance assessment of executive performance.

These ratios are mostly assessed by banks, creditors, and investors as part of their analysis. They want to know the entity’s health before providing credit terms, a loan or investing in the new fund.

These groups of stakeholders normally have high certainty that they are not too deeply involved with the entity when the ratios are too bad. This is also the reason why an entity needs to make sure the ratio looks good from time to time.

Conclusion:

You might need to add many other Liquidity Ratios to your ratios analysis based on the type of industries and other factors that your company is operating in.

To make your ratio speakable, the Liquidity ratio might need to compare with expectations, industry analysis, and or from the competitors. Besides just looking into cash flow, other non-financial factors should also be assessed.

For example, how well the entity grows in the market?

Who are the major shareholders of the entity?

Just because the liquidity ratios of the entity are not as good as bankers or creditors want, it does not mean they can not provide the loan or credit.

The credit terms and loans could still provide if the entity has a very strong financial position guarantor.

Written by Sinra