Liquidity Ratios
What Are Liquidity Ratios?
Liquidity ratios measure a company’s ability to pay off its short-term debts.
Liquidity ratios are an indication of a company’s financial health and its ability to meet its short-term obligations.
There are several liquidity ratios, but the two most common are the current ratio and the quick ratio. The cash ratio is also popular for more conservative readings of a company’s liquidity situation.
Liquidity Ratios – Key Takeaways
- Liquidity ratios are a class of financial metrics used to determine a company’s ability to pay off its short-term debt obligations. In other words, it measures a company’s solvency.
- There are three main liquidity ratios: the current ratio, quick ratio, and cash ratio.
- The current ratio is the most common liquidity ratio and is calculated by dividing a company’s current assets by its current liabilities.
- The quick ratio is similar to the current ratio but excludes inventory from the numerator (current assets), as inventory can take longer to sell and may not be able to be turned into cash quickly enough to cover short-term debts.
- The cash ratio is the most conservative liquidity ratio and is calculated by dividing a company’s cash and cash equivalents by its current liabilities.
- Liquidity ratios are important for creditors and investors to assess a company’s financial health and its ability to meet its short-term obligations.
- Generally, a higher liquidity ratio is better as it indicates that a company has a greater ability to pay off its short-term debts. However, too high of a liquidity ratio may indicate that a company is not efficiently using its assets.
Why Are Liquidity Ratios Important?
Liquidity ratios are important because they show how well a company can meet its short-term obligations.
This is important for two reasons:
- It shows whether or not a company will be able to pay its bills in the event of a sudden decrease in revenue.
- It shows whether or not a company will be able to take advantage of opportunities that require quick payment (such as a last-minute discount on inventory).
Types of Liquidity Ratios
There are three main types of liquidity ratios:
- The current ratio
- The quick ratio
- The cash ratio
The current ratio is the most common liquidity ratio. It measures a company’s ability to pay off its short-term debts with its current assets.
The quick ratio is similar to the current ratio, but it excludes inventory from the calculation. This makes it a more conservative measure of liquidity.
The cash ratio is the most conservative measure of liquidity. It only includes cash and cash equivalents in the calculation (such as marketable securities).
Liquidity Ratios – Current Ratio and Quick Ratio (Acid Test Ratio)
What Is a Good Liquidity Ratio?
There is no one “good” liquidity ratio, as it depends on the industry in which a company operates.
For example, companies in the retail industry typically have higher inventory levels and therefore need a higher current ratio than companies in other industries.
Current Ratio
The current ratio is the simplest and most commonly used liquidity ratio.
To calculate the current ratio, divide a company’s total current assets by its total current liabilities.
Current Ratio = Current Assets / Current Liabilities
For example, let’s say that ABC Company has $100,000 in cash, $50,000 in accounts receivable, and $20,000 in inventory.
So, its total current assets would be $170,000.
If ABC Company has $60,000 in accounts payable and $30,000 in short-term debt, its total current liabilities would be $90,000.
Its current ratio would be 1.89 ($170,000/$90,000).
This means that ABC Company has $1.89 in current assets for every $1 in current liabilities. In other words, it could pay off its short-term debts almost two times over with its current assets.
A current ratio of less than 1 means that a company does not have enough liquid assets to pay off its short-term debts. This is often a sign of financial distress.
A current ratio of more than 2 is generally considered to be good, but could also be too high. This could mean that a company is not using its assets efficiently and may be sitting on too much cash.
The ideal current ratio varies by industry.
For example, the retail industry has a higher average current ratio than the manufacturing industry because retailers typically need to keep more inventory on hand.
Quick Ratio
The quick ratio (also known as the “acid-test” ratio) is a more conservative measure of liquidity than the current ratio.
To calculate the quick ratio, divide a company’s total quick assets by its total current liabilities.
Quick Ratio = Quick Assets / Current Liabilities
Quick assets are current assets that can be quickly converted to cash, such as cash, accounts receivable, and marketable securities.
Inventory is excluded from the calculation because it can take longer to sell. In other words, physical goods are not as liquid.
Using the same example as above, let’s say that ABC Company has $100,000 in cash, $50,000 in accounts receivable, and $20,000 in inventory.
Its total quick assets would be $150,000 ($100,000 + $50,000). Its quick ratio would be 1.67 ($150,000/$90,000).
This means that ABC Company has enough quick assets to pay off its short-term debts with room to spare.
A quick ratio of less than 1 could be a sign of financial distress.
A quick ratio of more than 2 is generally considered to be too high, as it means that a company may not be using its assets efficiently.
As with the current ratio, the ideal quick ratio varies by industry.
Cash Ratio
The cash ratio is the most conservative measure of liquidity.
To calculate the cash ratio, divide a company’s total cash and cash equivalents by its total current liabilities.
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
Cash equivalents are short-term investments that can be quickly converted to cash, such as money market funds and short-term government bonds.
Liquidity Ratio Interpretation
Liquidity ratios are important for two reasons:
- To ensure a company can pay its bills in the event of a sudden decrease in revenue and
- To show whether or not a company will be able to take advantage of opportunities that require quick payment.
Liquidity Ratios for Banks
Banks are in the business of lending money, so they need to be sure they have enough cash on hand to meet customer demand.
The two most important liquidity ratios for banks are the loan-to-deposit ratio and the reserve ratio.
The loan-to-deposit ratio measures the percentage of a bank’s deposits that are being used to make loans.
The reserve ratio is the percentage of a bank’s deposits that it must keep on hand in order to meet customer withdrawals.
Loan-to-Deposit Ratio = Total Loans / Total Deposits
Reserve Ratio = Required Reserves / Total Deposits
A loan-to-deposit ratio of more than 100% means that a bank is lending out more money than it has on deposit.
A reserve ratio of 10% means that a bank holds 10% of its total deposits in cash.
Solvency and Liquidity Ratios
Solvency and liquidity are two important concepts in corporate finance.
Solvency ratios measure a company’s ability to repay its long-term debts.
Liquidity ratios measure a company’s ability to meet its short-term obligations.
There are several different ratios that can be used to measure solvency and liquidity.
Debt-to-assets, debt-to-equity, and interest coverage ratio
The most common are the debt-to-assets ratio, the debt-to-equity ratio, and the interest coverage ratio.
The debt-to-assets ratio measures the percentage of a company’s assets that are financed by debt.
Debt-to-Assets Ratio = Total Debt / Total Assets
A high debt-to-assets ratio indicates that a company is highly leveraged and may be at risk of defaulting on its debt obligations.
The debt-to-equity ratio measures the percentage of a company’s equity that is financed by debt.
Debt-to-Equity Ratio = Total Debt / Total Equity
A high debt-to-equity ratio indicates that a company is highly leveraged and may be at risk of defaulting on its debt obligations.
The interest coverage ratio measures a company’s ability to make interest payments on its debts.
Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Expense
A low interest coverage ratio indicates that a company may have difficulty making interest payments on its debts.
These ratios are valuable tools that can be used to measure a company’s financial health.
Ratios can be used to compare companies within the same industry or to compare industries as a whole.
When interpreting financial ratios, it is important to consider the context in which the ratios were calculated.
For example, a high debt-to-assets ratio may not be a cause for concern if the industry average is also high.
However, a high debt-to-equity ratio may indicate that a company is highly leveraged and may be at risk of defaulting on its debt obligations.
Similarly, a low interest coverage ratio may not be cause for concern if the company has a large amount of cash on hand to cover its interest payments.
What is the difference between solvency and liquidity?
Solvency and liquidity are two important financial concepts that are often used interchangeably, but they have different meanings.
Solvency refers to a company’s ability to pay its debts and obligations over the long term, while liquidity refers to a company’s ability to pay its short-term obligations.
A company can be solvent but not liquid, or liquid but not solvent.
A firm is said to be insolvent if it cannot pay its debts when they come due.
A company is said to be solvent if its assets exceed its liabilities. This means that the company has enough money to pay off all of its debts, even if it takes some time to do so.
A firm is considered illiquid if it does not have enough cash on hand to pay its short-term debts.
A company is said to be liquid if it has enough cash on hand to pay its short-term debts, and also has access to other forms of financing that can be used to meet its short-term obligations.
It is important for a company to maintain both solvency and liquidity, as they are both necessary for a company to stay in business.
If a company is insolvent, it will eventually have to declare bankruptcy. If a company is illiquid, it may not be able to meet its short-term obligations, which could lead to defaulting on loans or not being able to pay employees.
For example, a company may be solvent (i.e., a perfectly good business that produces more revenue than expenses and has more assets than liabilities), but be illiquid if it is slow collecting its revenue relative to the rate at which it pays its liabilities.
Both solvency and liquidity are important for a company to maintain, and both should be monitored closely.
FAQs – Liquidity Ratios
What do liquidity ratios measure?
Liquidity ratios measure a company’s ability to meet its short-term obligations.
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
What is the most common liquidity ratio?
The most common liquidity ratio is the current ratio.
What is the difference between a solvency ratio and a liquidity ratio?
Solvency ratios measure a company’s ability to repay its long-term debts, while liquidity ratios measure a company’s ability to meet its short-term obligations.
What are good liquidity ratios?
There is no definitive answer to this question, as it depends on the industry.
In general, higher ratios are better than lower ratios.
However, it is important to compare a company’s ratios to those of other companies in the same industry, as well as to the industry average.
What are the four liquidity ratios?
There are no set number of liquidity ratios. The most common are the current ratio, the quick ratio, and the cash ratio.
Two other common ratios include the debt-to-equity ratio and debt-to-assets ratio.
What is the acid test ratio?
The acid test ratio, also known as the quick ratio, measures a company’s ability to pay its short-term obligations with its most liquid assets.
What is the difference between the current ratio and the acid test ratio?
The current ratio measures a company’s ability to pay its short-term obligations with its current assets.
The acid test ratio measures a company’s ability to pay its short-term obligations with its most liquid assets.
How to calculate liquidity ratio?
The current ratio measures a company’s ability to pay its short-term obligations with its current assets.
To calculate the current ratio, divide a company’s current assets by its current liabilities.
Current Ratio = Current Assets / Current Liabilities
The quick ratio, also known as the acid test ratio, measures a company’s ability to pay its short-term obligations with its most liquid assets.
To calculate the quick ratio, subtract a company’s inventory from its current assets and divide the result by its current liabilities.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
The cash ratio measures a company’s ability to pay its short-term obligations with its most liquid assets.
To calculate the cash ratio, add a company’s cash and marketable securities and divide the result by its current liabilities.
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
Conclusion – Liquidity Ratios
Liquidity ratios are a type of financial ratio that measure a company’s ability to meet its short-term obligations.
The most common liquidity ratio is the current ratio.
To calculate the current ratio, divide a company’s current assets by its current liabilities.
A high current ratio indicates that a company has enough assets to cover its short-term liabilities.
A low current ratio may indicate that a company is at risk of defaulting on its debt obligations.