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 concerning the relationship between current assets and liabilities.

These ratios are 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, perform an assessment, and check if it is possible to provide a credit extension.

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

Once the supplier noted that the company probably faces a cash flow problem due to 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.

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.

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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.

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 the 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 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.

The entity’s board of directors also reviews these ratios 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 why an entity needs to make sure the ratio looks good from time to time.

What are the Limitations of Liquidity Ratios?

Liquidity ratios are financial metrics that measure a company’s ability to meet its short-term obligations. These ratios are commonly used by investors, analysts, and managers to evaluate a company’s liquidity position and ability to manage cash flow.

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However, liquidity ratios have limitations that must be considered when interpreting financial data. In this article, we’ll discuss some liquidity ratio limitations.

Limited Scope

Liquidity ratios provide a snapshot of a company’s liquidity position at a specific point in time. However, they must provide a complete picture of a company’s financial health.

Liquidity ratios do not consider factors such as profitability, solvency, and financial stability, which are critical to assessing a company’s long-term viability.

Industry and Business Model Differences

Different industries and business models have different liquidity norms. For example, a company operating in a highly cyclical industry may have lower liquidity ratios than one in a less cyclical industry.

Similarly, a company with a high inventory level may have lower liquidity ratios than a company with a lower inventory level. Thus, comparing liquidity ratios within the same industry and business model is essential.

Timing of Cash Flows

Liquidity ratios are affected by the timing of cash flows. For example, a company may have significant cash inflows from customers but significant cash outflows to suppliers, which can affect its liquidity ratios.

Similarly, a company may have a large cash balance at the end of the reporting period but may have significant cash outflows planned for the next reporting period. Thus, it is important to consider the timing of cash flows when interpreting liquidity ratios.

Temporary Effects

Liquidity ratios can be affected by temporary events that may not reflect a company’s overall liquidity position. For example, a company may have a one-time cash inflow from a non-recurring event, such as the sale of an asset, which can inflate its liquidity ratios.

Similarly, a company may have a temporary cash outflow due to a non-recurring event, such as a legal settlement, which can reduce its liquidity ratios. Thus, it is essential to understand the reasons behind any significant changes in a company’s liquidity ratios.

Limited Usefulness for Long-Term Analysis

Liquidity ratios may not be useful for long-term analysis of a company’s financial health. While liquidity ratios provide insight into a company’s short-term liquidity position, they do not provide information on the company’s ability to manage long-term cash flow and profitability.

Thus, other financial metrics such as cash flow from operations, return on assets, and return on equity may be more relevant for assessing a company’s long-term financial health.

What are the most common liquidity ratios?

There are several liquidity ratios that analysts and investors commonly use to evaluate a company’s liquidity position. The most common liquidity ratios are:

  1. Current Ratio: This ratio measures a company’s ability to meet its short-term obligations with its current assets. It is calculated by dividing current assets by current liabilities. A current ratio of 1 or greater is generally considered a good indicator of a company’s short-term liquidity position.
  2. Quick Ratio (or Acid-Test Ratio): This ratio is similar to the current ratio but excludes inventory from current assets since inventory may not be easily convertible to cash. The quick ratio is calculated by dividing quick assets (current assets – inventory) by current liabilities. A quick ratio of 1 or greater is generally considered a good indicator of a company’s ability to meet its short-term obligations.
  3. Cash Ratio: This ratio measures a company’s ability to meet its short-term obligations with cash and cash equivalents. The cash ratio is calculated by dividing cash and cash equivalents by current liabilities. A cash ratio of 0.5 or greater is generally considered a good indicator of a company’s ability to meet its short-term obligations.
  4. Operating Cash Flow Ratio: This ratio measures a company’s ability to generate cash from its operations to meet its short-term obligations. The operating cash flow ratio is calculated by dividing operating cash flow by current liabilities. A ratio of 1 or greater is generally considered a good indicator of a company’s ability to generate sufficient cash from its operations to meet its short-term obligations.
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These liquidity ratios can provide valuable insights into a company’s short-term liquidity position and ability to manage cash flow. 

However, it’s important to consider these ratios’ limitations and use them with other financial metrics when evaluating a company’s overall financial health.

What is the difference between solvency and liquidity?

Solvency and liquidity are important financial concepts that refer to different aspects of a company’s financial health.

Liquidity refers to a company’s ability to meet its short-term obligations as they become due. 

In other words, it measures how easily a company can convert its current assets into cash to pay its current liabilities. Liquidity ratios such as the current, quick, and cash ratios are used to assess a company’s liquidity position.

Solvency, on the other hand, refers to a company’s ability to meet its long-term obligations. It measures whether a company has enough assets to cover its long-term debts and other financial obligations.

Solvency ratios such as the debt-to-equity ratio, debt-to-assets ratio, and interest coverage ratio are used to assess a company’s solvency position.

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