Understanding Liquidity Ratios: Types and Their Importance (2024)

What Are Liquidity Ratios?

Liquidity ratios are a class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio.

Understanding Liquidity Ratios

Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios are most useful when they are used in comparative form. This analysis may be internalor external.

For example, internal analysis regarding liquidity ratios involves using multiple accounting periods that are reported using the same accounting methods. Comparing previous periods to current operations allows analysts to track changes in the business. In general, a higher liquidity ratio showsa company is more liquid and has better coverage of outstanding debts.

Alternatively, external analysis involves comparing the liquidity ratios of one company to another or an entire industry. This information is useful to compare the company's strategic positioning to its competitors when establishing benchmark goals. Liquidity ratio analysis may not be as effective when looking across industriesas various businesses require different financing structures. Liquidity ratio analysis is less effective for comparing businesses of different sizes in different geographical locations.

Types of Liquidity Ratios

The Current Ratio

Thecurrent ratiomeasures a company's ability to pay off its current liabilities (payable within one year) with its total current assets such as cash, accounts receivable, and inventories. Calculations can be done by hand or using software such as Excel. The higher the ratio, the better the company's liquidity position:

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$CurrentRatio=CurrentLiabilitiesCurrentAssets​

The Quick Ratio

The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assetsand therefore excludes inventories from its current assets. It is also known as the acid-test ratio:

$\begin{aligned} &\text{Quick ratio} = \frac{C + MS + AR}{CL} \\ &\textbf{where:}\\ &C=\text{cash \& cash equivalents}\\ &MS=\text{marketable securities}\\ &AR=\text{accounts receivable}\\ &CL=\text{current liabilities}\\ \end{aligned}$​Quickratio=CLC+MS+AR​where:C=cash&cashequivalentsMS=marketablesecuritiesAR=accountsreceivableCL=currentliabilities​

Another way to express this is:

$\text{Quick ratio} = \frac{(\text{Current assets - inventory - prepaid expenses})}{\text{Current liabilities}}$Quickratio=Currentliabilities(Currentassets-inventory-prepaidexpenses)​

Days Sales Outstanding (DSO)

Days sales outstanding (DSO)refers to the average number of days it takes a company to collect payment after it makes a sale. A high DSO means that a company is taking unduly long to collect payment and is tying up capital in receivables. DSOs are generally calculated on a quarterly or annual basis:

$\text{DSO} = \frac{\text{Average accounts receivable}}{\text{Revenue per day}}$DSO=RevenueperdayAverageaccountsreceivable​

Users of Liquidity Ratios

Liquidity ratios are utilized by a variety of people. There's one single purpose to liquidity ratios, and their versatility makes them useful to a number of different users. The following stakeholders in varying domains can each use liquidity ratios in distinct ways:

• Investors: Investors use liquidity ratios to assess the short-term financial health of companies in which they consider investing. By evaluating a company's liquidity position, investors can see the company's ability to meet immediate financial obligations. This is important when trying to reduce the risk of default and ensuring the safety of investing in only healthy companies.
• Creditors: Creditors, such as banks and financial institutions, rely on liquidity ratios to evaluate the creditworthiness of potential borrowers. By analyzing a company's liquidity position, creditors can assess the likelihood of timely repayment of loans or credit facilities. Higher liquidity ratios indicate a lower risk of default, providing creditors with greater confidence in extending credit to the company. Creditors may often impose liquidity ratio requirements as debt covenants.
• Analysts: Financial analysts use liquidity ratios as part of their comprehensive analysis of a company's financial performance and risk profile. By examining liquidity metrics, analysts can identify trends, assess potential liquidity risks, and make informed recommendations to investors or clients. Similar to individual investors, analysts attempt to evaluate the short-term health of a company prior to making decisions about that company.
• Management: Company management utilizes liquidity ratios to monitor and manage the organization's liquidity position. By tracking liquidity metrics regularly, management can identify liquidity gaps, optimize cash flow, and make informed decisions about short-term assets to carry.
• Regulators and Authorities: Regulators and governmental agencies may also use liquidity ratios as part of their oversight and regulatory functions. For instance, regulators impose restrictions on the minimum amount of cash a bank must have on hand at any given time; though this could be considered a loose interpretation of liquidity ratios, it's a good enough example of how regulators want to make sure certain types of entities have strong short-term liquidity.

Advantages and Disadvantages of Liquidity Ratios

Pros of Liquidity Ratios

One of the primary advantages of liquidity ratios is their simplicity and ease of calculation. This makes them accessible to investors, creditors, and analysts. These ratios offer a quick snapshot of a company's liquidity position without delving into complex financial analysis. For instance, the current ratio, which divides current assets by current liabilities, can quickly be determined by glancing at a company's balance sheet.

Another advantage of liquidity ratios is their utility in assessing a company's financial health and risk level. A high liquidity ratio suggests that a company possesses sufficient liquid assets to handle its short-term obligations comfortably. A low liquidity ratio may signal potential liquidity issues. Though a company's financial health can't simply boil down to a single number, liquidity ratios can simplify the process in evaluating how a company is doing.

Liquidity ratios also facilitate comparison across companies and industries. By benchmarking liquidity ratios against industry averages or competitors' metrics, stakeholders can identify strengths, weaknesses, and potential areas for improvement. For instance, you can compare Microsoft's current ratio against Google's current ratio to gauge how each company may be structured differently. This can be an important part in deciding between companies to invest in, especially if short-term health is one of your primary considerations.

Last, liquidity ratios can communicate operational efficiency. For instance, a declining liquidity ratio may indicate deteriorating financial health or inefficient working capital management. However, it may also mean a company is trying to hold onto less cash and deploy capital more rapidly to achieve growth.

Cons of Liquidity Ratios

One drawback of liquidity ratios is that these ratios provide a static view of a company's liquidity position at a particular point in time. This means they don't consider the dynamic nature of business operations and cash flows. For example, the current ratio may indicate sufficient liquidity based on current assets and liabilities, but it doesn't account for the timing of cash inflows and outflows. A company with high receivables and inventory turnover may have a healthy current ratio but struggle to convert these assets into cash quickly when needed.

As mentioned above under the advantages section, liquidity ratios may not always capture the full picture of a company's financial health. Tey focus solely on short-term liquidity. A company may maintain high liquidity ratios by holding excess cash or highly liquid assets, which could be more effectively deployed elsewhere to generate returns for shareholders. In addition, a company could have a great liquidity ratio but be unprofitable and losing money each year.

Last, liquidity ratios may vary significantly across industries and business models. Though we listed 'comparability' under the pro section, there is also risk that wrong decisions could be made when comparing different liquidity ratios. For instance, a capital-intensive industry like construction may have a much different operational structure than that of a service industry like consulting. Comparing the liquidity ratios of different companies may not always be comparable, fair, or truly informative.

Special Considerations

Aliquidity crisiscan arise even at healthy companies if circ*mstances arise that make it difficult for them to meet short-term obligations such as repaying their loans and paying their employees. The best example of such a far-reaching liquidity catastrophe in recent memory is the global credit crunch of 2007-09. Commercial paper—short-term debt that is issued by large companies to finance current assets and pay off current liabilities—played a central role in this financial crisis.

A near-total freeze in the $2 trillion U.S. commercial paper market made it exceedingly difficult for even the most solvent companies to raise short-term funds at that time and hastened the demise of giant corporations such as Lehman Brothers and General Motors (GM).

But unless the financial system is in a credit crunch, a company-specific liquidity crisis can be resolved relatively easily with a liquidity injection (as long as the company is solvent). This is because the company can pledge some assets if it is required to raise cash to tide over the liquidity squeeze. This route may not be available for a company that is technically insolvent because a liquidity crisis would exacerbate its financial situation and force it into bankruptcy.

Solvency Ratios vs. Liquidity Ratios

In contrast to liquidity ratios,solvencyratios measure a company's ability to meet its total financial obligations and long-term debts. Solvency relates to a company's overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current or short-term financial accounts.

A company must have more total assets than total liabilities to be solvent; a company must have more current assets than current liabilities to beliquid. Although solvency does not relate directly to liquidity, liquidity ratios present a preliminary expectation regarding a company's solvency.

The solvency ratio is calculated by dividing a company'snet incomeanddepreciationby its short-term andlong-term liabilities. This indicates whether a company's net income can cover itstotal liabilities. Generally, a company with a higher solvency ratio is considered to be a more favorable investment.

Profitability Ratios vs. Liquidity Ratios

Profitability ratios measure a company's ability to generate profit relative to its revenue, assets, or equity. These ratios assess the efficiency and effectiveness of a company's operations, providing insights into its ability to generate returns for shareholders. In contrast, liquidity ratios focus on a company's ability to meet its short-term financial obligations promptly.

While profitability ratios focus on generating returns and maximizing profits, liquidity ratios prioritize maintaining sufficient liquidity. It's important to understand these are vastly different things. A company can have sufficient money on hand to operate if it's built up capital; however, it may be draining the amount of reserves it has if operations aren't going well. Alternatively, a company may be cash-strapped but just starting out on a successful growth campaign with a positive outlook.

Both types of ratios are essential for assessing different dimensions of a company's financial performance and risk profile. Investors and analysts often use them in combination to gain an understanding of a company's financial health. Note that a company may be profitable but not liquid, and a company can also be highly liquid but not profitable.

Examples Using Liquidity Ratios

Let's use a couple of these liquidity ratios to demonstrate their effectiveness in assessing a company's financial condition.

Consider two hypothetical companies—Liquids Inc. and Solvents Co.—with the following assets and liabilities on their balance sheets (figures in millions of dollars).We assume that both companies operate in the same manufacturing sector (i.e., industrial glues and solvents).