Liquidity Ratios are the group of Financial Ratios that normally use for analyzing and measuring the liquidity position of the entity 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. Liquidity Ratio normally focuses on the group of ratios that measure how the company’s assets could handle its current liabilities.
It is very important for management to control the liquidity problem in the entity. Otherwise, the entity will not only face the cash flow problem but also less reliance from major suppliers and customers as most of them took seriously about these ratios.
We will discuss this in detail below.
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 credit extension or not.
In most of the case, liquidity ratios are among the most important ratios assess by those suppliers.
Once the supplier noted the company probably face the cash flow problem as the result of assessing the liquidity ratios, the suppliers probably feel uncertain to extend.
In addition, these ratios are also important from investors, bankers and customers’ points of view. The reason is if the company could not solve the liquidity problem, the company will subsequently face the 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 also concern about how long the company could play as their big supplier.
However, there are some disadvantages of using Liquidity Ratio. For example, by using only liquidity ratio to assess the liquidity problem in the company, the result of analysis seems not realistic because those ratios are the result of financial figure calculation which could be manipulated by management.
The better way to make analysis is to include these groups of ratios with other financial and non-financial ratios.
List of Most Used Liquidity Ratio:
There are many ratios that normally use to analyst the company’s liquidity problem. However, the following are the most use Liquidity 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.
Current Ratio is measure how the company’s current assets which normally include Inventories, Receivable, Cash and Cash Equivalents would cover Current Liabilities.
Current Ratio is said to be good if it is better than one. And if it is less than one, it means that current liabilities are bigger than current assets. The company may find it’s hard to pay current liabilities by using its current assets.
Quick Ratio is also the most popular liquidity ratio which we normally see in most of the assessment. This ratio measures the entity’s most liquid assets (Cash and Cash Equivalents) over its current liabilities.
This ratio disregard inventories in its calculation on the basis that inventories need a bit long time to convert into cash.
If this ratio gets more than once, that means 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 then divide them with current liabilities.
Noted: Quick ratio is also called acid-test ratio.
Cash Ratio is another liquidity ratio which is taken into account 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 Asset 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 lead to increase working capital ratio, and it is healthy when the ratio is higher than one.
Times Interest Earned Ratio:
Time Interest-Earning Ratio is also the Liquidity Ratio that use to assess and measure whether the entity’s profit before interest and tax could cover its current interest expenses or interest charge or not. Sometimes we use interest expenses or sometimes we use interest charged.
These two are the same thing. If this ratio gets more than one, it means that the company generates enough profit to cover its interest charge.
Yet, if this ratio is smaller than one, the company might need to find other funds to pay its interest charged.
Why is it so important to calculate liquidity ratios?
There are many reasons why the liquidity ratios are calculated and assess. The entity itself might want to assess its own liquidity ratios to ensure that the entity is not gonged to be rate down due to poor liquidity ratio by creditors, bankers, shareholders, and other related stakeholders.
These ratios also review by the entity’s board of directors as their performance assessment on executive performance.
These ratios mostly assess by banks, creditors, and investors as part of their analysis. They want to know how healthy the entity is before providing credit terms, a loan or investing in the new fund.
These groups of stakeholders normally have high certainty 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 look good from time to time.
There are many other Liquidity Ratios that you might need to add to your ratios analysis base on the type of industries and other factors that your company is operating in.
To make your ratio speak-able, Liquidity ratio might need to compare with expectation, industry analysis, and or from the competitors. Besides just looking into cash flow, other non-financial factors should be 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