Liquidity Ratio

When it comes to financing, liquidity is a crucial aspect to consider. Liquidity ratio is an essential accounting tool that is used to determine the current debt-repaying ability of a borrower.

What is Liquidity Ratio

Liquidity Ratio is a measure used for determining a company's ability to pay off its short-term liabilities.

This ratio reflects whether an individual or business can pay off short-term dues without any external financial assistance. Considering the liquid assets, present financial obligations are analysed to validate the safety limit of a company.

If the liquidity ratio is higher, it is easier to pay off the debts.

Types of Liquidity Ratios

Possessing a substantial amount of liquid assets provides the ability to pay off short-term financial obligations on time. Here are the liquidity ratio types, along with a detailed liquidity ratio formulae–

• Current Ratio

The current ratio implies the financial capacity of a company to clear off its current obligations by using its current assets.

Here the current assets include cash, stock, receivables, prepaid expenditures, marketable securities, deposits, etc. Current debts include short-term loans, payroll liabilities, outstanding expenses, creditors, various other payables, etc.

Formula:

Current Ratio = Current Assets / Current Liabilities

Any current ratio lower than 1 implies a negative financial performance for that business or individual. A current ratio below one is indicative of one’s inability to pay off the present-time monetary obligations with their assets.

Example of Current Ratio:

• Quick Ratio or Acid Test Ratio

Quick ratio or acid test ratio is another liquidity ratio that determines a company’s current available liquidity.

Easily convertible (in cash) marketable securities and present holding of cash are considered while calculating the quick ratio. Hence, inventories are excluded when the acid test ratio is concerned.

Formula:

1. Quick Ratio = (Marketable Securities + Available Cash and/or Equivalent of Cash + Accounts Receivable) / Current Liabilities
   
   
2. Quick Ratio = (Current Assets – Inventory) / Current Liabilities

A 1:1 quick ratio is ideal and reflects the stable financial position of a company.

Example of Quick Ratio:

• Cash Ratio

The cash or equivalent ratio measures a company’s most liquid assets, such as cash and cash equivalent to the entire current liability of the concerned company.

As money is the most liquid form of assets, this ratio indicates how quickly and to what limit a company can repay its current dues with the help of its readily available assets.

Formula:

Cash Ratio = Cash and Equivalent / Current liabilities

• Absolute Liquidity Ratio

The absolute liquidity ratio pits marketable securities, cash and equivalents against current liabilities. Businesses should strive for an absolute liquidity ratio of 0.5 or above.

Formula:

Absolute Liquidity Ratio = (Cash and Equivalent + Marketable Securities)/Current Liabilities

Example of Absolute Liquidity Ratio:

• Basic Defence Ratio

The basic defence ratio is an accounting metric that determines how many days a company can run on its cash expenses without any outside financial aid. It is also called the defensive interval period and basic defence interval.

Formula:

Basic Defence Ratio = Current Assets/Daily Operational Expenses

Current Assets = Marketable Securities + Cash and Equivalent + Receivables

Daily Operational Expenses = (Annual Operational Costs – Non-cash Expenses)/365

Example of a Basic Defence Ratio:

• Basic Liquidity Ratio

Contrary to the above-stated ratios, the basic liquidity ratio is not related to the company’s financial position. Instead, it is an individual’s financial ratio that denotes a timeline for how long a family can finance its needs with its liquid assets. A minimum of 3 months of monetary backup is desirable.

Formula:

Basic Liquidity Ratio = Monetary Assets / Monthly Expenses

Importance of Liquidity Ratio

As a useful financial metric, the liquidity ratio helps to understand the financial position of a company.

• The liquidity ratio helps to understand the cash richness of a company. It also helps to perceive the short-term financial position.
  
  A higher ratio implies the stability of the company. Contrarily, a poor ratio carries a risk of monetary damages.
  
  
• This ratio provides the complete idea of the concerned company’s operating system. It depicts how effectively and efficiently the company sells its products or services to convert the inventories into cash.
  
  With the help of this ratio, a company can improve the production system, plan better inventory storage to avoid any loss and prepare effective overhead expenses.
  
  
• A company’s financial stability also depends on its management. Hence, considering this ratio, a company can also optimise its management efficiency in following the demands of potential creditors.
  
  
• With the help of this ratio, company management can also work towards the betterment of its working capital requirements.

Limitations of Liquid Ratio

• Similar to the number of liquid assets, quality also plays a crucial part. This ratio only considers the amount of a company’s current assets. Thus, it is advisable to consider other accounting metrics along with liquidity ratios to analyse a company’s liquid strength.
  
  
• The liquidity ratio involves inventory to calculate a company’s liquidity. However, this can lead to a miscalculation due to overestimation. Higher inventory can also be a reason for fewer sales. Hence, inventory calculation might not provide the real liquidity of a company.
  
  
• This ratio might also be an outcome of creative accounting, as it only includes the balance sheet information. To understand the financial position of an organisation, analysts must go beyond the data on the balance sheet to perform a liquidity ratio analysis.