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When it comes to financing, liquidity is a crucial aspect to consider. And liquidity ratio is an essential accounting tool that is used to determine the current debt repaying ability of a borrower. Simply, this ratio reflects whether an individual or business can pay off the short term dues without any external financial assistance.
Considering the liquid assets, present financial obligations are analysed to validate the safety limit of a company.
Types of Liquidity Ratios
Possessing a substantial amount of liquid assets provides the ability to pay off short-term financial obligations on time. Here are the available liquidity ratio types–
Current ratio implies the financial capacity of a company to clear off the current obligations by using its current assets. Here the current assets include cash, stock, receivables, prepaid expenditures, marketable securities, deposits, etc. And, current debts include short-term loans, payroll liabilities, outstanding expenses, creditors, various other payables, etc.
Current ratio = current assets / current liabilities
Any current ratio lower than 1 implies a negative financial performance for that business or individual. A current ratio below one is indicative of one’s inability to pay off the present time monetary obligations with their assets.
Example of current ratio:
|Current assets||Current liabilities||Current ratio (current assets / current liabilities)|
|Rs. 260 crore||Rs. 130 crore||Rs. 260 crore / Rs. 130 crore = 2:1|
Quick ratio or Acid test ratio
Quick ratio or acid test ratio is another liquidity ratio that determines a company’s current available liquidity. Easily convertible (in cash) marketable securities and present holding of cash are considered while calculating the quick ratio. Hence, inventories are excluded when acid test ratio is concerned.
- Quick ratio = (marketable securities + available cash and/or equivalent of cash + accounts receivable) / current liabilities
- Quick ratio = (current assets – inventory) / current liabilities
1:1 quick ratio is ideal and reflects a stable financial position of a company.
Example of quick ratio:
|Particulars of current assets||Amount in crore|
|Cash and equivalent||Rs. 65,000|
|Marketable securities||Rs. 15,000|
|Accounts receivables||Rs. 35,000|
|Total current assets||Rs. 160,000|
|Total current liabilities||Rs. 60,000|
|Current ratio||As per formula 1 = (Rs. 65,000 + Rs. 15,000 + Rs. 35,000)/ Rs. 60,000
= Rs. 115,000/Rs. 60,000
As per formula 2 = (Rs. 160,000 – Rs. 45,000)/Rs. 60,000
= Rs. 115,000/Rs. 60,000
Cash or equivalent ratio measures a company’s most liquid assets such as cash and cash equivalent to the entire current liability of the concerned company. As money is the most liquid form of assets, this ratio indicates how quickly, and to what limit a company can repay its current dues with the help of its readily available assets.
Cash ratio = Cash and equivalent / Current liabilities
Absolute liquidity ratio
Absolute liquidity ratio pits marketable securities, cash and equivalents against current liabilities. Businesses should strive for an absolute liquidity ratio of 0.5 or above.
Absolute liquidity ratio = (Cash and equivalent + marketable securities)/current liabilities
Example of absolute liquidity ratio
|Particulars of liquid assets||Amount in crore|
|Cash and equivalent||Rs. 1,65,000|
|Marketable securities||Rs. 75,000|
|Accounts receivables||Rs. 90,000|
|Current liquid assets||Rs. 4,30,000|
|Particular of Current liabilities||Amount|
|Bills payables||Rs. 90,000|
|Bank overdraft||Rs. 80,000|
|Outstanding expenses||Rs. 30,000|
|Total current liabilities||Rs. 3,00,000|
|Absolute liquidity ratio||(Rs. 1,65,000 + Rs. 75,000)/Rs. 3,00,000
= Rs. 2,40,000/Rs. 3,00,000
Basic defence ratio
The basic defence ratio is an accounting metric that determines how many days a company can run on its cash expenses without any outside financial aid. It is also called the defensive interval period and basic defence interval.
Basic defence ratio = current assets/daily operational expenses
Current assets = marketable securities + cash and equivalent + receivables
Daily operational expenses = (annual operational costs – non-cash expenses)/365
Example of a basic defence ratio:
|Particulars of liquid assets||Amount in crore|
|Cash and equivalent||Rs. 1,05,000|
|Marketable securities||Rs. 55,000|
|Accounts receivables||Rs. 80,000|
|Current liquid assets||Rs. 2,40,000|
|Particular of daily operational expenses||Amount|
|Annual operating cost||Rs. 5,00,000|
|Non-cash expenses||Rs. 70,000|
|Daily operational expenses||Rs. 4,30,000/365 = 1178|
|Basic defence ratio||Rs. 2,40,000/1178
Basic liquidity ratio
Contrary to the all above-stated ratios, the basic liquidity ratio is not related to the company’s financial position. Instead, it is an individual’s financial ratio that denotes a timeline for how long a family can finance its need with its liquid assets. A minimum of 3 months of monetary backup is desirable.
Basic liquidity ratio = Monetary assets / monthly expenses
Importance of Liquidity Ratio
As a useful financial metric, the liquidity ratio helps to understand the financial position of a company.
- The liquidity ratio helps to understand the cash richness of a company. It also helps to perceive the short-term financial position. A higher ratio implies the stability of the company. Contrarily, a poor ratio carries a risk of monetary damages.
- This ratio provides the complete idea of the concerned company’s operating system. It depicts how effectively and efficiently the company sells its product or services to convert the inventories into cash. With the help of this ratio, a company can improve the production system, plan better inventory storage to avoid any loss, and prepare effective overhead expenses.
- A company’s financial stability also depends on its management. Hence, considering this ratio, a company can also optimise its management efficiency in following the demands of potential creditors.
- With the help of this ratio, company management can also work towards the betterment of its working capital requirements.
Limitations of Liquid Ratio
- Similar to the number of liquid assets, quality also plays a crucial part. This ratio only considers the amount of a company’s current assets. Thus, it is advisable to consider other accounting metrics along with liquidity ratios to analyse a company’s liquid strength.
- The liquidity ratio involves inventory to calculate a company’s liquidity. However, this can lead to a miscalculation due to overestimation. Higher inventory can also be a reason for fewer sales. Hence, inventory calculation might not provide the real liquidity of a company.
- This ratio might also be an outcome of creative accounting, as it only includes the balance sheet information. To understand the financial position of an organisation, analysts must go beyond the data on the balance sheet to perform a liquidity ratio analysis.
A liquidity ratio can reveal one of three financial indicators.
- Liquidity ratio of one: If a company’s current assets equal its current liabilities, then it will have a liquidity ratio of one. In other words, its current assets could pay for one hundred percent of its current short-term debt.
- Liquidity ratio of less than one: If a company’s liquidity ratio is less than one, the company does not have enough cash (or cash equivalents) to meet its short-term debt obligations. For instance, a liquidity ratio of 0.75 means that the company only has enough cash on hand to pay 75 percent of its short-term liabilities. This could foretell a liquidity crisis.
- Liquidity ratio over one: If a business’s current ratio measures greater than one, it has more than enough liquid assets to cover the short-term debts on its balance sheet. For instance, a financial statement that shows a liquidity ratio of two suggests that the company has enough cash assets (or the equivalent) to pay its liabilities two times over.
3 Ways to Use a Liquidity Ratio
Liquidity ratios reveal numerous insights about a company.
- Solvency: Liquidity ratios are essentially solvency ratios. If a company does not have enough liquid assets to quickly pay off short-term debt and liabilities, it may teeter on the edge of bankruptcy.
- Profitability: While some startups may endure heavy debt as part of their early existence, a well-established business needs to be profitable to survive. If a company cannot manage to have a steady cash flow many years into its existence, it may not be designed for profitability.
- Billing: Some companies struggle to maintain a reasonable amount of cash on hand because their customers don’t pay their bills on time. The Days Sales Outstanding (DSO) ratio compares the balance of accounts receivable to the revenue a company makes in a day. Accounts receivable does not factor into all liquidity ratios, but it is a key component of the quick ratio, which is favored by some accounting managers and investment bankers.