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Liquidity ratios are used to measure the financial health of a business. These metrics are used by banks and creditors to determine loan eligibility, and by investors to decide if the company is a safe investment. The liquidity ratio helps the company itself determine if they have too little capital or have a surplus of capital that can be put to use.
What is a Liquidity Ratio?
The liquidity ratio is a comparison of a company’s liquid assets versus their current liabilities. It essentially answers the question, “If this company was forced to pay off all of its debts right now, would it be able to?”
If a company has $100,000 in liabilities, $50,000 in cash, and $50,000 worth of stocks then it could sell the stocks to raise enough money to completely eliminate their outstanding debt. A company that has the ability to pay off all of its outstanding debt is considered liquid. A company that can only pay off a portion of their debt is considered illiquid. The ratio of assets to liabilities is a company’s liquidity ratio.
Types of Liquidity Ratios
There are three types of liquidity ratios: the current ratio, the quick ratio, and the cash ratio.
The Current Ratio
The current ratio measures a company’s ability to pay its liabilities for the next year with its current assets. Current assets are defined as cash and cash equivalents, along with non-liquid assets like inventory and real estate. For the current ratio you’re comparing a year’s worth of liabilities against assets that could be liquidated within that same time frame.
A current ratio of 1:1 means that a company can pay off all of the liabilities that are due within a year with nothing left over. The current ratio is also referred to as the “working capital ratio” because if a business has much more cash (and liquid assets) on hand than they need to pay off their debts, this working capital could be invested into the company.
The formula for the current ratio is:
Current Ratio = Current Assets / Current Liabilities
The Quick Ratio
The quick ratio (also referred to as the “acid-test ratio”) is another type of liquidity ratio. The quick ratio is different from the current ratio in two ways: the quick ratio includes a company’s accounts receivable, but excludes any assets that can’t be converted into cash quickly. Quick assets are defined as any assets that can be converted into cash within ninety days.
Stocks, bonds, and other liquid assets are included, but the quick ratio excludes assets that could not be exchanged for their full value within ninety days. These non-liquid assets include a company’s inventory, real estate, and vehicles.
If a business has $100,000 in liabilities and for assets it only has a $1,000,000 painting, it would fail the acid-test, because although the painting is worth far more than the liabilities, you probably wouldn’t be able to find a buyer at that price within the span of ninety days.
The formula for the quick ratio is:
Quick Ratio = Cash (and cash equivalents) + Market Securities + Accounts Receivable / Current Liabilities
The Cash Ratio
The cash ratio is stricter than both the current ratio and the quick ratio when comparing a company’s assets against their liabilities. The cash ratio measures a company’s liabilities against just its cash or near-cash equivalents.
The cash ratio ignores near-liquid assets, the company’s inventory, and accounts receivable. The cash ratio determines how much debt the business could pay off right away, without having to sell any assets.
Cash ratio = Cash (and cash equivalents) / Current liabilities
Days Sales Outstanding (DSO)
Days sales outstanding determines the amount of time between when the company makes a sale, and when the company collects the payment for that sale. Companies may sell products to another business but not require the payment for several weeks or months. Businesses with a very high DSO should make an effort to collect payment faster, and businesses with an extremely low DSO may be inhibiting sales by demanding payment too quickly.
DSO is helpful when evaluating the liquidity of a business because it can identify cash flow issues when the number of days sales outstanding is too high.
DSO = Average accounts receivable / Revenue per day
Why Are Liquidity Ratios Important?
Liquidity ratios are an important metric for the owners of a business, creditors, and investors. The liquidity ratio states the financial health of a company in the near future by showing it has the ability to pay off all of its short-term liabilities. Understanding how much (or how little) of a financial cushion a company has helps it make important decisions like using excess working capital or applying for a loan.
A liquidity ratio that is greater than 1 reassures banks that it’s safe to provide a company with a loan. If the business has a liquidity ratio of less than 1 they cannot pay back their current liabilities and will likely be ineligible for a loan.
Investors use the liquidity ratio when considering a business as a potential investment. A low or negative liquidity ratio is a strong indicator of where a business will be in the next several months and could scare off investors. If a company has an extremely high liquidity ratio it indicates that they have an excess of working capital that they should be using to reinvest and expand the business. By tapping into excess liquidity a company can improve the share value for investors.
What is a Good Liquidity Ratio?
A 1:1 liquidity ratio is good because it means the business could pay off all of their liabilities if needed. Unfortunately, a 1:1 to ratio would mean that the company would have absolutely no cash on hand after paying off the liabilities so companies strive to have a liquidity ratio that is greater than 1.
A liquidity ratio of 2:1 would mean the company has enough assets to pay off all of their liabilities twice. A liquidity ratio that is less than 1 means that the company could not pay off all of their liabilities if they needed to and indicates the company’s on-hand cash and cash equivalents are too low.
In instances where a company has an extreme liquidity ratio it would indicate that capital is being underused. If their ratio was 5:1 they have far more cash on hand than they reasonably need to repay debts and some of that excess money should be invested into the company.
The Difference Between Liquidity Ratios & Solvency Ratios
Liquidity and solvency are both measurements of a company’s ability to pay off its liabilities. The difference is that liquidity refers to short-term debt obligations while solvency measures the ability to pay off long-term debt and continue to operate. Solvency ratios look much farther into the future than a liquidity ratio, but they are used in tandem to determine the financial health of a business.
Every business is focused on growth and longevity. Understanding a company’s short-term liquidity helps EquityNet analyze promising startups and before recommending them to investors. Keeping track of liquidity is essential to spot any potential funding issues in the near future, and help companies proactively increase their holdings to maintain liquidity.
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