What are the liquidity ratios?
Liquidity ratios are an important class of financial parameters used to determine the ability of a debtor to repay current debts without raising external capital. Liquidity ratios measure a company’s ability to pay its debts and its safety margin by calculating parameters, including the current ratio, the rapid ratio and the operating cash flow ratio.
Current liabilities are analyzed against liquid assets to assess the coverage of short-term debts in the event of an emergency.
Key points to remember
- Liquidity ratios are an important class of financial parameters used to determine the ability of a debtor to repay current debts without raising external capital.
- Current liquidity ratios include the quick ratio, the current ratio and the days of sales in progress.
- Liquidity ratios determine a company’s ability to cover its short-term obligations and its cash flows, while solvency ratios concern a longer-term ability to pay its debts.
Use of liquidity ratios
What do the liquidity ratios tell you?
Liquidity is the ability to convert assets into cash quickly and at low cost. Liquidity ratios are most useful when used in comparative form. This analysis can be internal or external.
For example, the internal analysis concerning the liquidity ratios involves the use of several accounting periods declared according to the same accounting methods. Comparing previous periods to current operations allows analysts to track changes in the business. In general, a higher liquidity ratio shows that a company is more liquid and has better coverage of outstanding debts.
Alternatively, external analysis involves comparing liquidity ratios from one company to another or to an entire industry. This information is useful for comparing the strategic positioning of the company in relation to its competitors when establishing benchmarks. Analyzing the liquidity ratio may not be as effective when looking at different sectors, because different companies require different funding structures. Analysis of the liquidity ratio is less effective in comparing companies of different sizes in different geographic areas.
Common liquidity ratios
The current ratio
The current ratio measures the capacity of a company to repay its current liabilities (payable within one year) with its current assets such as cash, accounts receivable and inventories. The higher the ratio, the better the liquidity position of the company:
Current Ratio=Current liabilitiesCurrent assetsTheThe
The rapid ratio measures the ability of a company to meet its short-term obligations with its most liquid assets and therefore excludes stocks of its current assets. It is also known as the “acid-test report”:
TheQuick Ratio=VSTheVS+MS+ARTheor:VS=Cash and cash equivalentsMS=marketable securitiesAR=accounts receivableVSThe=current liabilitiesTheThe
Another way to express this is:
Quick Ratio=Current liabilities(Current assets – inventory – prepaid expenses)TheThe
Days of current sale (DSO)
DSO refers to the average number of days it takes a business to collect payment after making a sale. A higher DSO means that a company is taking too long to collect payment and is blocking the principal of the receivables. DSOs are generally calculated quarterly or annually:
DSO=Income per dayAverage debtorsTheThe
A liquidity crisis can occur even in healthy companies if circumstances arise that prevent them from meeting their short-term obligations such as paying off their loans and paying their employees. The best example of a liquidity disaster of such magnitude in recent memory is the global credit crisis of 2007-2009. Commercial paper – short-term debt issued by large companies to finance current assets and pay off current liabilities – played a central role in this financial crisis.
An almost total freeze on the US commercial paper market of $ 2 trillion made it extremely difficult for even the most creditworthy companies to raise short-term funds at that time and hastened the demise of giant companies such as Lehman Brothers and General Motors Company (GM). .
But unless the financial system is in crisis, a company-specific liquidity crisis can be relatively easily resolved by injecting liquidity, as long as the company is solvent. Indeed, the company can pledge certain assets if necessary to raise funds to counter the liquidity squeeze. This route may not be available for a technically insolvent company, as a liquidity crisis would worsen its financial situation and force it into bankruptcy.
The difference between solvency ratios and liquidity ratios
Unlike liquidity ratios, solvency ratios measure the ability of a business to meet its total financial obligations. Creditworthiness is linked to a company’s overall ability to pay debts and continue trading, while liquidity is more focused on current financial accounts. A business must have more total assets than total liabilities to be solvent and more current assets than current liabilities to be liquid. Although solvency is not directly related to liquidity, liquidity ratios present a preliminary expectation regarding the solvency of a business.
The solvency ratio is calculated by dividing a company’s net profit and depreciation by its short-term and long-term liabilities. This indicates whether a company’s net income is able to cover its total liabilities. Generally, a company with a higher solvency ratio is considered a more favorable investment. (See also: Solvency ratio vs liquidity ratios)
Examples of liquidity ratios
Let us use some of these liquidity ratios to demonstrate their effectiveness in assessing the financial condition of a business.
Take two hypothetical companies, Liquids Inc. and Solvents Co., the following assets and liabilities on their balance sheets (figures in millions of dollars). We assume that the two companies operate in the same manufacturing sector (i.e. industrial adhesives and solvents).
|Balance sheet (millions of dollars)||Liquids Inc.||Solvents Co.|
|Cash||$ 5||$ 1|
|Marketable securities||$ 5||$ 2|
|Accounts receivable||$ 10||$ 2|
|inventories||$ 10||$ 5|
|Current assets (a)||$ 30||$ 10|
|Factory and equipment (b)||$ 25||$ 65|
|Intangible assets (c)||$ 20||$ 0|
|Total assets (a + b + c)||$ 75||$ 75|
|Current liabilities * (d)||$ 10||$ 25|
|Long-term debt||$ 50||$ 10|
|Total liabilities (d + e)||$ 60||$ 35|
|Equity||$ 15||$ 40|
* In our example, we will assume that current liabilities include only accounts payable and other liabilities, with no short-term debt.
- Current Ratio = $ 30 / $ 10 = 3.0
- Quick Ratio = ($ 30 – $ 10) / $ 10 = 2.0
- Equity debt = $ 50 / $ 15 = 3.33
- Debt on assets = $ 50 / $ 75 = 0.67
- Current Ratio = $ 10 / $ 25 = 0.40
- Quick Ratio = ($ 10 – $ 5) / $ 25 = 0.20
- Equity debt = $ 10 / $ 40 = 0.25
- Debt on assets = $ 10 / $ 75 = 0.13
We can draw a number of conclusions about the financial position of these two companies from these ratios.
Liquids Inc. has a high degree of liquidity. According to its current ratio, it has $ 3 of current assets for each dollar of short-term liabilities. Its quick ratio indicates adequate liquidity even after stocks are excluded, with $ 2 of assets that can be quickly converted into cash for every dollar of current liabilities.
However, leverage based on its solvency ratios appears to be quite high. Debt exceeds equity by more than three times, while two-thirds of assets have been financed by debt. It should also be noted that almost half of non-current assets consist of intangible assets (such as goodwill and patents). Therefore, the debt-to-tangible assets ratio – calculated as ($ 50 / $ 55) – is 0.91, which means that over 90% of tangible assets (factories, equipment and stocks, etc.) have have been financed by debt. In summary, Liquids Inc. has a comfortable liquidity position, but its leverage is dangerously high.
Solvents Co. is in a different position. The company’s current ratio of 0.4 indicates an insufficient level of liquidity with only 40 cents of current assets available to cover each dollar of current liabilities. The quick ratio suggests an even more dire liquidity position, with only 20 cents of liquid assets for every dollar of short-term liabilities.
However, financial leverage seems to be at comfortable levels, with debt representing only 25% of equity and only 13% of assets financed by debt. Best of all, the company’s asset base consists entirely of tangible assets, which means that the debt-to-tangible asset ratio of Solvents Co. is approximately one-seventh that of Liquids Inc. (approximately 13% versus 91%). Overall, Solvents Co. is in a dangerous liquidity situation, but its debt position is comfortable.