What are liquidity ratios?
A liquidity ratio is a financial statistic that assesses an organization's ability to fulfill its short-term loan commitments. The indicator determines whether an organization's current or liquid assets can pay its current obligations. The current, quick, and cash ratios are the three most widely utilized liquidity ratios. The current liabilities amount is put in the denominator of each liquidity ratio, while the liquid assets amount is placed in the numerator.
Ratios over 1.0 are desired due to the ratio framework, with assets on top and liabilities on the bottom. A ratio of one indicates that a company's current assets are sufficient to cover all its obligations. A ratio of less than one (e.g., 0.75) indicates that a corporation cannot meet its present obligations. A ratio larger than one (e.g., 2.0) indicates that a corporation can pay its existing debts. In reality, a ratio of 2.0 indicates that a company's existing obligations may be covered twice over. A ratio of 3.0 indicates that their existing obligations might be covered three times over, and so on.
The concept of liquidity ratios
The ability to turn assets into cash rapidly and cheaply is called liquidity. When used in comparison, liquidity ratios are the most beneficial. This examination might be internal or external. For example, an internal study of liquidity ratios requires using numerous accounting periods that are stated using the same accounting procedures. Analysts may keep track of changes in the corporation by comparing historical periods to present operations. A greater liquidity ratio indicates that a corporation is more liquid and has better debt coverage.
External analysis, however, entails contrasting the liquidity ratios of one business to another or a whole sector. When creating benchmark targets, this information may be employed to assess the organization's strategic stance compared to its rivals. A liquidity ratio study may not be as advantageous when evaluating various industries since different firms demand different funding arrangements. Liquidity ratio analysis is less useful when comparing enterprises of various sizes in different geographical areas. Liquidity ratios compare current liabilities to liquid assets to assess the capacity to meet short-term debts and commitments in an emergency.
Varieties of liquidity ratios
i. Current ratio
The current ratio is the easiest liquidity ratio to calculate and explain. On a balance sheet, anybody may quickly locate the current assets and liabilities line items.
Current ratio = Current assets / current liabilities
ii. Quick ratio
The quick ratio is a more stringent liquidity test than the current ratio. Both have the same numerator and denominator in that current assets are the numerator, and current liabilities are the denominator.
Nevertheless, the quick ratio only takes into account specific current assets. It considers more liquid assets, including cash, accounts receivable, and marketable securities. Current assets like inventories and prepaid costs are excluded since they are less liquid. Consequently, it is a more accurate indicator of the capacity of a corporation to meet its short-term commitments.
Quick ratio = (C + MS + AR) / CL
C = cash & cash equivalents
MS = marketable securities
CL = current liabilities
AR = accounts receivable
iii. The cash ratio
The cash ratio pushes the liquidity test even further. This ratio solely considers a company's most liquid assets: cash and convertible bonds. They are the holdings that a corporation has the most easily accessible to satisfy short-term commitments.
The current, fast, and cash ratios are classified as easy, medium, and hard regarding how stringent the liquidity standards are.
Cash ratio = (Cash + Marketable securities) / Current liabilities
iv. DSO (Days sales outstanding)
Days sales outstanding (DSO) is the average number of days it takes for a business to recover payment after making a sale. A high DSO indicates that a corporation is taking excessive time to collect payments and is tying up money in receivables. DSOs are often measured quarterly or annually.
DSO = Average accounts receivable / Revenue per day
Even strong enterprises can have a liquidity crisis if conditions make it impossible to meet short-term obligations such as loan repayment and employee pay. The worldwide credit crisis of 2007-09 is the most recent instance of such a wide-reaching liquidity disaster. Commercial paper, a short-term debt issued by firms to finance current assets and pay current lenders, was key to the financial crisis.
A near-complete freeze in the $2 trillion commercial paper market in the United States made it very challenging for even the most solvent firms to acquire short-term funding at the time, hastening the downfall of big organizations like Lehman Brothers and General Motors (GM).
However, if the economic system is in a state of credit shortage, a firm-specific liquidity crisis (as long as the company is viable) may be handled relatively simply with a liquidity injection. It is because the corporation may pledge certain assets if it needs to obtain cash to get through the liquidity crisis. An officially insolvent firm may be unable to choose this path since a liquidity crisis would aggravate its financial predicament and drive it into bankruptcy.
Factors influencing liquidity ratios
An organization's liquidity ratios may be influenced by several variables, including:
i. Industry guidelines
Businesses have different liquidity needs; thus, using liquidity ratios to compare organizations across industries may not produce realistic findings. When assessing these ratios, experts must take into account industry-specific standards.
ii. Business cycles
Business cycles may influence liquidity ratios since firms' cash flow and working capital needs fluctuate at various periods.
iii. Size and structure of the organization
A corporation's size and structure may influence its liquidity ratios since bigger organizations may have more diverse income streams and greater access to funding. In contrast, smaller enterprises may have fewer resources and increased liquidity risk.
The significance of liquidity ratios
i. Determine your capacity to meet your short-term commitments.
Liquidity ratios help investors and creditors judge if a firm can meet its short-term commitments and to what extent. A ratio of one is preferable to a less than one, although it is not optimal.
Increased liquidity ratios, such as 2 or 3, are preferred by creditors and investors. The greater the ratio, the more probable a corporation can pay its short-term expenses. A ratio less than one indicates that the firm has negative working capital and may suffer a liquidity issue.
ii. Assess creditworthiness
Creditors use liquidity measures to determine whether or not to offer credit to a firm. They want to ensure that the firm they lend can pay them back. Any signal of financial insecurity may preclude a corporation from acquiring financing.
iii. Determine the quality of an investment.
Investors will use liquidity measures to determine if a firm is financially sound and deserving of its investment. Working capital constraints will also impact the remainder of the firm. A corporation must be competent to pay its short-term obligations with considerable wiggle room.
Low liquidity ratios are a warning sign, but the adage "the higher, the better" is only accurate to a point. Shareholders will eventually wonder why a firm's liquidity ratios are so elevated. Yes, a firm with a liquidity ratio of 8.5 can pay its short-term payments confidently, but investors may consider such a ratio excessive. A high ratio indicates that the firm has substantial liquid assets.
For instance, if a firm's cash ratio was 8.5, analysts and shareholders could think it was excessive. The corporation has too much cash on hand, generating little more than the interest rate offered by the bank to store its cash. It might be argued that the funds should be allocated to other activities and investments that would provide a larger return.
Liquidity ratios compromise a company's ability to securely meet its obligations and inefficient capital deployment. Capital should be deployed in the most efficient manner possible to improve the firm's value for shareholders.
The drawbacks of liquidity ratios
While liquidity ratios are important financial instruments, they do have various drawbacks:
i. Uncertainty in reporting requirements
Discrepancies in liquidity ratios may result from differences in accounting procedures and reporting standards among organizations and sectors, making comparisons difficult.
ii. Inability to grasp the whole financial perspective
Liquidity ratios are concerned with short-term financial health and may not accurately represent a company's financial situation.
iii. Possible for misleading outcomes
Financial engineering may alter liquidity ratios, resulting in deceptive results that may not represent a company's financial health.
Liquidity ratios vs. solvency ratios
Unlike liquidity ratios, solvency ratios assess a company's capacity to satisfy its complete financial commitments and long-term debts. Solvency refers to a company's total capacity to pay debts and maintain operations, while liquidity is mainly concerned with current or short-term accounting records.
To be solvent, a firm must have more overall assets than total liabilities; to be liquid, a corporation must possess fewer current liabilities than current assets. Even though solvency is not directly related to liquidity, liquidity ratios estimate a company's solvency early.
An organization's solvency ratio is computed by dividing its net income and depreciation by immediate and long-term obligations. This metric reflects if the net earnings of a business are sufficient to pay its entire obligations. Generally, a firm with a greater solvency ratio is considered a better investment.
Analysis and comprehension of the liquidity ratios
The cash status of the firm may be analyzed by calculating the different liquidity ratios, as shown in the example above. In this case, the current ratio is 250%. It indicates that the corporation has more current assets accessible than short-term obligations to service, which is a good indicator.
Nevertheless, if liquidity is construed more broadly and the quick ratio is considered, the ratio is lower but still adequate at 213%. The corporation may pay its creditors in full without selling assets from inventory quickly.
The cash ratio is significantly tighter, with only the most liquid funds included. The firm could still service 88% of its commitments but would have to dispose of some of its goods or wait longer for Revenue from accounts receivable.
What constitutes a good liquidity ratio?
One could suppose that a corporation should strive for the greatest liquidity ratios feasible. It, nonetheless, is not the case. A reference point of 200% for the current ratio is considered solid. This implies the corporation always has enough current assets to cover its short-term commitments.
If the current ratio was just 100%, the corporation could barely pay its obligations with its current assets. An unexpectedly hefty cost might soon put the firm in financial jeopardy. The quick ratio should have a value of 100%. This is to guarantee that the company's obligations are covered without selling assets from inventory.
A cash ratio of 20% is a reasonable starting point. Although this implies that most liquid funds can only cover a tiny portion of your obligations, corporations embrace this risk for development reasons. A large amount is idle if the cash ratio is exceptionally high and cannot be utilized for investments or expansion.
Liquidity ratios are important tools in financial research because they give useful information about a company's capacity to satisfy its short-term commitments. Despite their shortcomings, these ratios remain important in credit research, investment choices, and management assessment. When analyzing the findings of liquidity ratios, it is critical to consider aspects such as industry norms, economic cycles, and firm size and structure to assess a firm's financial health thoroughly.