Liquidity ratios are important financial metrics used to assess a company's ability to pay current debt obligations. The two most common liquidity ratios are the current ratio and the quick ratio.
What Are Liquidity Ratios?
Liquidity ratios are key financial ratios used by internal and external analysts to gauge a company's liquidity, which represents its capacity to pay its existing short-term liabilities if it needs to without the assistance of additional financing. The primary liquidity ratio formula is as follows:
Liquidity Ratio = Liquid assets / Short-term liabilities
By taking the company's total liquid assets, including cash and securities that can readily be converted to cash, and dividing it by its short-term liabilities, liquidity ratios can tell analysts and investors if the company is likely to meet its short-term obligations should the need arise.
The information needed to calculate liquidity ratios is found on the company's balance sheet, where current assets and current or short-term liabilities are listed.
Why Liquidity Ratios are Important
A company's liquidity is an indication of how readily it can obtain cash needed to pay its bills and other short-term obligations. Companies need sufficient liquidity through cash on hand or easily converted securities to meet their obligations while still covering payroll, paying vendors, and maintaining operations.
Companies with high liquidity have a solid cash and current accounts position with the ability to cover short-term liabilities. Companies with low liquidity could have trouble doing so without the help of external financing, which could be harder to raise if they are truly in a financial predicament.
When tracked across multiple accounting periods, liquidity ratios reveal whether a company's liquidity is improving or worsening. When measured across companies within the same industry, liquidity ratios assist analysts and investors in assessing which companies may be in a stronger liquidity position.
Comparing liquidity ratios is less effective when analyzing companies' finances in different industries or when there is a wide variance in the size of the companies being analyzed, as they might require different financing structures. Also, when using liquidity ratios, it's essential to put them in the context of other metrics and company trends to provide a more accurate picture of a company's financial health.
Short of a system-wide credit crunch that can limit funds in the banking system, companies can sometimes resolve a liquidity problem by pledging some of their assets to raise cash unless it is also insolvent.
Key Takeaway: Companies need sufficient liquidity through cash on hand or easily converted securities to meet their obligations while continuing to cover payroll, pay vendors, and maintain operations.
Common Liquidity Ratios
Generally, all liquidity ratios measure a company's ability to meet its short-term obligations. But they do it with different views of the balance sheet. The two more common variations of the liquidity ratio are the current ratio and the quick ratio.
Current Ratio
The current ratio is a simple comparison of your business's total current assets and current liabilities to gauge its financial strength. It answers a critical question, which is, "Does my business have enough current assets to cover its current liabilities, with a margin of safety?"
Current ratio = Current assets / Current liabilities
A business with $130,000 of total current assets and $80,000 of total current liabilities has a current ratio of 1.6
$130,000 / $80,000 = 1.6
This tells you that the business's current liabilities are covered by current assets 1.6 times, which appears sufficient. Some analysts view a current ratio above 1.5x as an indication of good financial health. Companies with current ratios below 1.5 may be seen as more likely to potentially experience cash flow issues. On the other hand, a high current ratio may indicate that cash is not being utilized optimally.
Quick Ratio
The quick ratio is similar to the current ratio, except it removes inventory from the equation, so it is a more accurate test of a company's true liquidity. It's also known as the acid-test ratio. The formula is as follows:
Quick Ratio = (Current Assets - Inventories) / Current Liabilities*
Some analysts also deduct prepaid expenses in calculating a Quick Ratio
For example:
- Current assets = $50,000
- Inventory = $20,000
- Current liabilities = $15,000
Quick Ratio = ($50,000 - $20,000) / ($15,000) = ($30,000) / ($15,000) = 2
An alternate formula to calculate the quick ratio is as follows:
Quick Ratio = (Cash & Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
The quick ratio may be favorable if a company's ability to readily convert its inventory into cash at fair value is in doubt. Otherwise, the current ratio may overstate its liquidity position. A quick ratio above 1 is generally regarded as safe depending on the type of business and industry.
Key Takeaway: Because it excludes inventories, the quick ratio provides a more accurate measure of a company's ability to convert current assets into cash efficiently.
Liquidity Ratio Examples
To understand how liquidity ratios can be used to assess a company's financial condition, consider this hypothetical example of two companies, using a side-by-side comparison of their balance sheets. The companies are competitors in the same industry.
Balance Sheets for Company x & Company Y
Company X Company Y Cash & Cash Equivalents $10 $2 Marketable Securities $10 $4 Accounts Receivable $20 $4 Inventories $20 $10 Current Assets (a) $60 $20 Plant and Equipment (b) $50 $130 Intangible Assets (c) $40 $0 Total Assets (a + b + c) $150 $150 Current Liabilities* (d) $20 $50 Long-Term Debt (e) $100 $20 Total Liabilities (d + e) $120 $70 Shareholders' Equity $30 $80
Company X:
- Current Ratio = $60 / $20 = 3.0
- Quick Ratio = $60 - $20 / $20 = 2.0
Company Y:
- Current Ratio = $20 / $50 = 0.40
- Quick ratio = ($20 - $10) / $25 = 0.20
Relative to Company Y, Company X has a high degree of liquidity with the ability to cover its current liabilities three times over. Even with the stricter quick ratio, it has sufficient liquidity with $2 of assets to cover every dollar of current liabilities after excluding inventories.
Company Y has a current ratio of 0.4, potentially suggesting it has insufficient liquidity. It has just $0.40 to cover each dollar of current liabilities. Excluding inventories, the quick ratio shows a dangerously low degree of liquidity, with only 20 cents of liquid assets to cover every dollar of current liabilities.
Liquidity vs. Solvency Ratios
Whereas liquidity ratios measure a company's ability to meet its short-term obligations, solvency ratios are used to measure its ability to meet total financial obligations, including long-term debts. While a company's solvency is a longer term consideration, its liquidity ratios could point to potential solvency issues in the future. For a company to be considered liquid, it should typically have more current assets than current liabilities.
Important: While a company's solvency does not necessarily have anything to do with its liquidity, liquidity ratios can reveal potential solvency issues in the future.
Bottom Line
Companies need liquidity to pay their bills. Liquidity ratios measure a company's capacity to meet its short-term obligations and are a vital indicator of its financial health. They are also useful when comparing the financial strength of companies within the same industry. Liquidity is different than solvency, which measures a company’s ability to pay all its debts.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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