Liquidity ratios are fundamental in forecasting the future cash flows of the firm. They are widely used for this purpose and for deciding about financing mix, capital structure, investment, etc.
These liquidity ratios are used to measure a company's ability to pay its short-term obligations. Liquidity ratios provide information about a company's ability to meet its short-term financial obligations by comparing current assets to current liabilities.
Investors use banks and other business organizations to measure a firm's ability to meet its short-term financial obligations. Liquidity refers to the ease with which an asset can be turned into cash. The primary liquidity ratios are the quick assets ratio, current ratio, acid-test ratio, and debt to equity ratio.
Here is an overview of the key points covered:
- What is Liquidity?
- Tangible Assets versus Intangible Assets in Liquidity ratios
- What do Current Liabilities in Liquidity Ratios include?
- What are the Different Types of Liquidity Ratios?
- What is a quick ratio?
- What is the Current Ratio?
- What is the Cash Ratio?
- What is the Acid-Test Ratio?
- What is the Receivables Turnover?
Purchasing power is an essential factor when determining the potential liquidity ratios
For example, suppose there are not enough liquid assets in the business to purchase inventory needed for the next month's sales. In that case, it will have to delay purchases until more liquidity is available. This may lead to lost sales and ultimately affect cash flow.
Liquidity ratios are used to evaluate how well-positioned a company is to meet its short-term obligations. In other words, liquidity ratios let investors know whether or not a firm has enough cash on hand to pay off its debts and bills as they become due. The most common liquidity ratios are the current ratio, which compares its existing assets to its current liabilities.
What is Liquidity?
Liquidity refers to the ease with which an asset can be converted into cash. For example, an office building has little liquidity because it cannot be readily converted into cash. On the other hand, money in bank accounts is easily convertible into cash.
This means that companies with more assets that can be quickly converted into cash are considered more liquid than those with fewer assets.
Liquidity ratios are used by management to assess a company's ability to pay its short-term debts and liabilities. Liquidity ratios provide a snapshot of liquidity, which is the ability of a company to pay its short-term obligations. A high liquidity ratio indicates that the firm can quickly meet its short-term obligations. On the other hand, firms with a low ratio will struggle to pay their short-term obligations.
For example, if an organization has $250 in cash and $250 in accounts receivable, the quick ratio would be 1:1. Or, if the organization has $2000 in cash and $1000 in accounts payable, the quick ratio would be 2:1. This would mean that the company has twice as much money on hand as its short-term operational liabilities.
Tangible Assets versus Intangible Assets in Liquidity Ratios
Tangible assets are things that we can touch and feel. These include cash, stocks, inventory, buildings, and machinery. In contrast, intangible assets are nonphysical and cannot be touched or felt. Examples of intangible assets include patents, goodwill, and brand equity.
Tangible assets such as cash and marketable securities are considered "current." That means they are expected to be converted into cash or used next year. Accounts receivable, inventory, and prepaid expenses are "noncurrent" items. They are not likely to be converted into cash within the following year.
Tangible net worth is calculated as follows:
Tangible Net Worth = Total Assets – Intangibles – Goodwill – Deferred Taxes
Intangible assets include patents, brand names, copyrights, and goodwill. For example, if Company XYZ has a patent on a specific product, the patent represents an intangible asset.
If Company XYZ pays more for another company than the value of the tangible assets of that company, the excess amount paid would be counted as goodwill. Goodwill does not have any monetary value associated with it and cannot be sold separately from the company.
Total assets = cash + marketable securities + accounts receivable + inventory + prepaid expenses + fixed assets + intangible assets – liabilities
What do Current Liabilities include in Liquidity Ratios?
Tangible assets are those that can be converted into cash within twelve months. Current assets include cash and short-term investments, accounts receivable, inventory (work in process), marketable securities, and prepaid expenses.
Current liabilities include short-term debt and accounts payable. The current ratio measures a company's ability to pay off its short-term obligations with its liquid or convertible assets. It is calculated by dividing total existing assets by total current liabilities.
Any figure over 1 means that the company has enough working capital to cover its short-term liabilities with ease. A low figure indicates that the company might have trouble meeting its obligations in the short run. If a company has significant long-term debt, then the long-term debt should be subtracted from the total current assets before calculating the current ratio.
What are the Different Types of Liquidity Ratios?
Liquidity ratios measure a company's ability to pay short-term obligations. Liquidity ratios evaluate the short-term financial health of a company by counting the number of current assets compared to current liabilities. The three primary liquidity ratios are the current, quick, cash, and acid-test ratios.
By using these liquidity ratios, investors can determine whether a company has enough cash on hand to pay its immediate bills. If a company fails any of these tests, it is considered "liquidity challenged." This means that it either has insufficient cash on hand or too many short-term liabilities (payables) to pay its bills.
In other words, liquidity ratios indicate whether a company has sufficient cash to cover its immediate obligations.
These liquidity ratios can be used as an additional metric for measuring solvency, along with debt-to-equity ratio, capitalization, and others.
What is a quick ratio?
It is used to measure the ability of a business to meet its short-term obligations. This ratio is also called "acid-test," "quick assets," or "quick assets ratio."
Liquidity ratios are calculated based on working capital. There are three main liquidity ratios: current, quick, and cash.
Working capital is defined as current assets minus current liabilities. Current assets are short-term, highly liquid assets such as cash, marketable securities, etc. Current liabilities are short-term, high-interest-bearing debts such as short-term debt and accounts payable.
The quick ratio formula is:
Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities
The typical liquidity ratio for a healthy business might be 1:1, meaning the company has $1 in liquid assets for every $1 in short-term debt. A higher number indicates that a firm has more resources available to pay off their debts, while a lower number means they may have trouble meeting their obligations.
For example, assume that a business has $600 in cash and $1,000 in accounts receivable, and $300 in inventory. Its accounts payable equals $300, it has a bank loan of $400, and its total current liabilities are $1,000. The quick ratio would be computed as follows:
Cash + Accounts Receivable + Inventory - Accounts Payable / Total Current Liabilities = 1.2 : 1
What is the Current Ratio?
Current liabilities are short-term debts and obligations that are due within one year, such as trade payables, short-term loans, and taxes. The current ratio indicates a company's ability to meet its short-term obligations with its liquid or "current" assets.
A high current ratio means that a company has enough liquid assets to cover its immediate needs. A low current ratio indicates that a company may have difficulty paying its upcoming bills and seek additional financing to continue operations.
For straightforward liquidity ratios, the Current Ratio measures a company's ability to pay off its short-term debt obligations with its short-term assets.
The formula for calculating the Current Ratio is:
Current Assets / Current Liability = Current Ratio
Another way of looking at the Current Ratio is that it tells us what percentage of current liabilities can be paid off with current assets. For example, assume that Company A has $100 million in current assets and $50 million in current liabilities. Thus, Company A has a Current Ratio of 2 ($100 million / $50 million = 2).
What is the Cash Ratio?
A cash ratio is a financial ratio used to assess a company's liquidity position. The cash ratio measures the proportion of a company's assets that are "cash" or "cash equivalents" (such as short-term government securities).
Assets are first classified into current assets and non-current assets. Current assets include cash, short-term investments, accounts receivable, inventories, and prepaid expenses. Non-current assets include non-current investments and long-term receivables.
The cash ratio is calculated as follows:
Cash ratio = Cash + Short term investment + Short term bank deposits = Total Current Assets − Total Current Liabilities
Example: Cash Ratio = $250,000 + $50,000 − $130,000 = 0.9
This implies that the company has $0.90 of cash for every $1.00 of its total current liabilities (also known as a working capital requirement). The higher the cash ratio, the better for the company since it has sufficient liquid assets to pay off its short-term obligations such as trade payables and short-term loans.
The acceptable range of cash ratio varies by industry, and it is usually between 0 and 2. Some industries require the companies to hold even more of their assets in cash, such as utilities and telecommunications, where the acceptable range is 0 to 1.50.
What is Acid-Test Ratio?
The acid-test ratio measures the quality of a company's current assets. It measures the proportion of liquid assets to current liabilities. The Acid-test ratio is also known as the quick, or fast, ratio.
If a company has a high acid-test ratio, it can pay for its current liabilities from its liquid assets. The lower the acid-test ratio is, the more likely it is that the company will face liquidity problems in the future.
The formula for calculating acid-test ratio is:
Acid-Test Ratio = (Cash + Marketable Securities) / Current Liabilities
The formula states that the acid-test ratio should equal (cash plus marketable securities) divided by current liabilities.
The total assets are divided by the total current liabilities and then multiplied by 100 to give you an acid-test ratio. A good indicator that your acid-test ratio is high is if two times your assets are equal to or greater than your current liabilities.
Company XYZ has $10 million in tangible net worth and $3 million in current liabilities. The acid-test ratio for Company XYZ would be calculated as follows: ($10m - $0) / $3m = 3
The higher the number, the better because it indicates that the company has enough cushion to pay off its short-term obligations if necessary.
What is the Receivables Turnover?
The receivables turnover ratio tells you how fast a company collects money from its customers. A high receivables turnover ratio means that the company is managing its receivables quickly, and it has less uncollected money sitting around.
The formula for calculating receivable Turnover is:
Receivable Turnover = Net Credit Sales / Average Total Current Accounts Receivable
A company has $2,000,000 in credit sales for the year and $1,000,000 in accounts receivable at the beginning of the year. At the end of the year, the company has collected all but $200,000 of that amount. The receivable turnover ratio (receive sales/AR) is:
Receivable Turnover = ($2,000,000) / ($1,000,000 + $200,000) = 2.0
What does this mean? It means that this company collected its accounts receivable 2-times faster than it sold credit and had an average AR balance of just one-fifth of its annual credit sales. This demonstrates strong collection abilities on the company's part.
Liquidity ratios are a financial metric that measures a company or an individual's ability to meet short-term debt obligations. It is a measure used by analysts to determine a company's solvency.
Though these liquidity ratios may be considered simplistic, they're instrumental in determining if a company will survive adverse economic conditions.
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- Liquidity ratios are financial ratios that measure a company's ability to pay short-term and long-term debts. They are used in financial analysis to determine a company's overall health
- A company with good liquidity ratios is more likely to pay its debts on time, while one with poor liquidity ratios may be struggling to stay afloat
- Liquidity ratios can be calculated in both absolute terms and relative terms. Absolute liquidity ratios show the actual amount of a company's liquid assets compared to its short-term debt obligations
- A relative liquidity ratio compares the firm's liquidity to other firms in the same industry or sector with similar operating cycles and businesses
- There are five primary liquidity ratios: current ratios, quick ratios, cash ratios, acid-test ratios, and receivables Turnover, respectively
At Deskera, we use an interactive tool to determine the financial strength of a company and the ability to generate cash internally through the liquidity ratios.