Liquidity ratio is a ratio that informs one's potential to repay their debt after they are due. This ratio also informs how fast an agency can convert its modern-day property into cash to repay its due amount. Generally, liquidity and short-time period solvency are used together.
Liquidity ratios are important to determine a debtor's ability to meet their current debt without borrowing further. The current ratio measures a company's debt repayment capacity and safety margin by calculating indicators such as the quick ratio, current ratio and operating cash flow ratio.
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Liquidity is a critical aspect of any business. The higher the ratio, the easier it will be for the company to pay its short term liabilities. If a company defaults, it seriously affects the credit rating of the company.
Types of Liquidity Ratio
Quick Ratio
Quick ratio excludes inventory from working capital to measure a company's ability to meet short-term debt with its liquid assets. This is also known as the acid test ratio.
Current Ratio
The company's ability to repay short-term debt (paid within a year) with the sum of current assets such as accounts receivable, cash and inventories is known as the current ratio. With a higher liquidity ratio, the company’s position becomes better in repaying the short term debts.
Basic Defence ratio
This ratio measures the number of days a company can meet its cash spending without the help of additional funding from other sources.
Cash Ratio
The liquidity ratio measures a company's liquidity, precisely the ratio of the company's cash and cash equivalents to current liabilities. It is also known as the absolute liquidity ratio.
Liquidity is the capability to convert assets into cash cheaply and quickly. Liquidity indicators are most useful when used in a comparative format. This analysis can be done internally or externally. Analysts can track changes in their business by comparing the previous year with their current business year. A high quick ratio indicates that the entity is more liquid and better covers its outstanding debt. Out of the different liquidity ratios, quick, cash, and current ratios are very important and are commonly used. Let’s understand each ratio and liquidity ratio formula.
Also Read: Know about Balance Sheet - Definition & Examples
Cash Ratio
The cash ratio is like the value indicator of a firm in a worst-case scenario, such as an indicator of a company's value when the company is about to give up on its operations. It informs analysts and creditors of the value of current assets that can be quickly converted to cash and what percentage of the company's current liabilities that these cash and cash equivalents can cover.
Compared to other liquidity indicators, the quick ratio generally excludes cash or cash equivalents on hand and other assets, including accounts receivable.
The formula for calculating the quick ratio is as follows:
Cash Ratio = (Cash Marketable Securities) / Current Liabilities
Cash and cash equivalents. Like other current liabilities, we use current liabilities as to the denominator in the current ratio formula. Current liabilities include all obligations that need to be paid within one year. Current liability also accounts for payable and accounts payable.
The main difference is in the counter. The quick ratio numerator limits the asset portion of the equation to the most liquid assets, such as in hand cash, cash equivalents and demand deposits, including money market accounts, treasury bills and savings accounts.
Accounts receivable, prepaid assets, inventories and certain investments are not included in the liquidity ratio like any other liquidity indicator. The reason is that these items may take time and effort to find a buyer in the market. In addition, the amount received from the sale of these assets may be uncertain.
The cash ratio is commonly used to measure a company's liquidity. If a firm is forced to pay all current liabilities without notice, this metric shows the company's capability to pay without liquidating other assets. The current ratio is expressed as a number greater than or less than 1. When calculating, if the ratio result is 1, the entity has the equivalent amount of current liabilities as cash equivalents and cash to repay the debt.
Current Ratio
Current ratios above the industry average are generally acceptable. A current ratio below the industry average indicates default or risk of default. Likewise, companies with a very higher current ratio than their peers indicate that management may not use their assets efficiently.
In contrast to the liquidity indicators, the current ratio is named current because it includes all current liabilities and assets. The current ratio is also mentioned as the working capital ratio. To calculate the ratio, you need to compare the company's current liabilities to its current assets. Current assets displayed on the company's balance sheet include accounts receivable, inventories, cash or the other current assets that are awaited to be available as monetisation or liquidation within one year.
Current liabilities cover wages, current liabilities, accrued taxes, the current portion of fixed liabilities and the accounts payable. The formula of the current ratio is:
Current ratio = Current assets / Current liabilities
A ratio of less than 1 specifies that a company's debt matures within one year is more than its assets ( short-term assets expected to be converted to cash within one year or cash). It may seem alarming if the current ratio is less than 1.00, but various situations can adversely affect the current ratio in a solid company.
Theoretically, the higher the current ratio, the higher the ratio of current assets to the value of current liabilities, which allows a company to better fulfil its obligations. A high percentage (e.g. 3.00 and above) may indicate that the company can cover short-term debt more than three times, but it does not use working capital efficiently, has sufficient funds, and so on. It does its job with well-managed capital.
Firms that appear to have a bearable current ratio may be heading into a situation where they are having a hard time paying invoices.
Conversely, companies that appear to be grappling now may be well on their way to a healthier current ratio.
Also Read: What is the meaning of Gross Working Capital?
Quick Ratio
The quick ratio is an index of a company's brief-period liquidity position and calculates its ability to meet short-term debt with its most liquid assets. This is also known as the endurance test ratio. It shows the company's ability to pay current liabilities using cash-equivalent assets (which can be quickly converted to cash). The acid test is a slang term for rapid testing designed to provide immediate results. Quick ratio only considers short-term debt and the most liquid assets available to repay debt. Cash can be quickly and easily converted to cash to pay invoices and short-term debts.
The formula to calculate the quick ratio is:
QR=CA−I−PE / CL
Or
QR=CE+MS+AR / CL
QR=Quick Ratio
MS=Marketable Securities
CE=Cash & Equivalents
CA=Current Assets
AR=Accounts Receivable
CL=Current Liabilities
PE=Prepaid Expenses
I=Inventory
PE=Prepaid Expenses
A result of 1 is considered a normal quick ratio. This shows that the company is fully funded with sufficient assets to quickly liquidate to pay off its current liabilities. Companies with a quick ratio of less than one may not be able to repay their current liabilities in full. In contrast, companies with a quick ratio greater than one may be able to repay their current liabilities immediately.
Liquidity Ratio Example
Particular |
Amount |
Short-Term Investment |
64 |
Cash equivalent and cash |
2189 |
stock |
8334 |
Receivables |
1076 |
Other current assets |
254 |
Total current assets |
11917 |
Outstanding expenses |
4565 |
Account payable |
804 |
Taxes payable |
306 |
Income tax payable |
999 |
Deferred Revenue |
226 |
Other outstanding expenses |
1135 |
Total Current Liability |
8035 |
From the above data :
Current Ratio = current assets/ current liabilities
Therefore, current ratio = 11917/8035 = 1.48
Again, Quick Ratio = current assets- inventory/ current liabilities
Quick Ratio= 11917-8334/8035 = 0.45
Now,
Cash Ratio = (Cash Marketable Securities) / Current Liabilities
Cash Ratio= 2189 64/8035 = 0.28
Thus, we can easily calculate liquidity ratios with the help of the formulas.
Ideal Liquidity Ratio
A company's liquidity is its ability to repay debt. If the quick ratio is over 1, then it will be better. This indicates that the company is in good financial condition and is unlikely to have any financial problems. The higher the ratio, the safer and easier it is for the company to meet its current liabilities. The current ratio is commonly used by lenders or creditors when deciding whether to lend to a company.
Conclusion
Liquidity ratio is an important part of business. It is necessary and helps the company meet its short-term obligations. The quick ratio measures a company's ability to repay current liabilities. The liquidity index determines how a company can transform assets to pay its current debts. The higher the ratio, the easier it is to repay debt and avoid defaults.
This is an important criterion for lenders to check before offering a short-term loan to a company. Organisations that cannot pay their current debt on time are going to inevitably affect their credit score and the company’s creditworthiness.
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