Are you an investor looking to understand the financial health of a company? One of the key metrics you should be familiar with is the liquidity ratio. It provides vital insights into a company’s ability to meet its short-term obligations.

In this blog post, we’ll learn the concept of liquidity ratios, explore their importance, and different types, and learn how to calculate them. By the end, you’ll have a solid understanding of how to assess a company’s financial liquidity and make informed investment decisions.

What is the Liquidity Ratio?

The Liquidity Ratio is a set of financial ratios that measure a company’s ability to promptly meet its short-term financial obligations. It helps determine how quickly a company or business can pay its due short-term creditors out of its total cash. Amongst the financial burden, the liquidity ratio determines a company’s capacity to settle its short-term debts without external intervention.

Types of Liquidity Ratios

There are several key types of liquidity ratios offering a distinct perspective on a company’s flexibility:

1. Current Ratio

Current ratio indicates a firm’s liquidity status. It is a widely used matrix that assesses a company’s ability to cover its current liabilities (debts due in a financial year) with its current assets (resources that can be converted to cash in a year). 

The formula for calculating the current ratio is:

Current Ratio = Current Assets / Current Liabilities

A current ratio greater than one indicates that the company has more current assets than current liabilities and can pay them off quickly using its current assets. Similarly, the ratio below one suggests that a company may struggle to meet its obligation to pay off. 

Consider this as an example, a small Indian textile company has a current ratio of 2.5. This means that for every ₹1 of current liabilities (such as accounts payable and short-term loans), the company has ₹2.5 of current assets (like cash, accounts receivable, and inventory). A current ratio of 2.5 suggests that the company is in a relatively strong position to meet its short-term obligations. 

2. Quick Ratio

Quick ratio, also known as the acid-test ratio, measures a company’s ability to burn its current liabilities immediately with its near-cash or quick-access assets. It is considered one of the most liquid assets (cash, accounts receivable, and market securities) while excluding less liquid assets like inventory and prepaid expenses. 

The formula for calculating the quick ratio is:

Quick Ratio =  Liquid Assets / Quick Liabilities

Or, more specifically,

Quick Ratio = (Cash & Cash Equivalent + Marketable Securities + Accounts Receivable) / Current Liabilities

Furthermore, it can be expressed as:

Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities

A higher quick ratio indicates better short-term financial health, as it suggests the company has sufficient cash or assets that can be quickly converted to cash to meet its immediate obligations. A lower quick ratio may signal potential liquidity issues.

For example, a small Indian tech startup has current assets of ₹25 lakh, which includes ₹5 lakh in inventory and ₹10 lakh in cash. Its current liabilities are ₹15 lakh. To calculate the quick ratio, we subtract the inventory from the current assets: ₹25 lakh – ₹5 lakh = ₹20 lakh. Then, we divide the result by the current liabilities: ₹20 lakh / ₹15 lakh = 1.33. This indicates that the company has ₹1.33 of quick assets for every ₹1 of current liabilities, suggesting a healthy liquidity position.

3. Cash Ratio

Cash ratio is more restrictive than the current & quick ratio as no current assets other than cash and cash equivalents can be used to pay off current debts. It is the most conservative measure of liquidity. The formula for calculating the cash ratio is:

Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

The cash ratio is one of the critical ratios creditors give importance to. It helps them know whether the business entity can meet a stable cash balance and pay off their debts as they come due. The cash ratio, more significant than one, means the company can settle its short-term liabilities using its cash reserve alone. This ratio also reflects a company’s capacity to pay its short-term debts without relying on other assets or sources of liquidity.

Consider this example, a small FMCG company has a cash balance of ₹10 crores and cash equivalents of ₹5 crores. Therefore, its cash ratio is 1.5 (₹15 crores / ₹10 crores). This indicates that Tech Innovations has sufficient cash and cash equivalents to cover its current liabilities 1.5 times over, suggesting a strong liquidity position.

Importance of Liquidity Ratios

Liquidity ratios hold significant value in financial analysis for various stakeholders. It is due to several reasons:

  • Assessing Financial Health: The Liquidity Ratio provides insights into a company’s health by evaluating its ability to manage short-term obligations. Companies with a healthy liquidity ratio get credits approved quite quickly and lower the risk of defaulting on debt, giving investors more confidence. A strong liquidity position also means financial stability and resilience to economic downturns.
  • Facilitating Decision-Making: The Liquidity Ratio gives stakeholders more informed decision-making powers regarding investment, lending, and strategic planning. It also helps provide a more mature way to assess the risk associated with a company’s short-term financial stability. A strong liquidity ratio helps analyze the risks associated with investing in a company, while lenders or creditors use it to evaluate its creditworthiness.
  • Detecting Financial Distress: The declining or falling liquidity ratios mean financial distress within the company. It prompts stakeholders to take corrective measures to improve financial distress and the company’s liquidity position. Efficient capital management ensures smooth company operations while balancing assets and liabilities. 

Things to Consider When Analysing Liquidity Ratios

The liquidity ratios provide valuable insights, and it’s essential to consider them when assessing your financial decision-making process. The trends in a company’s liquid ratio can reveal potential areas of improvement, highlight emerging issues, and avoid bankruptcy. For individuals, it is important to consider being abreast of the company’s liquidity when making data comparisons amongst various other companies.

Conclusion

In conclusion, liquidity ratios are essential for evaluating a company’s liquidity position and financial health. Moreover, stakeholders can gain valuable insights into a company’s ability to meet short-term obligations and manage cash flow effectively by analysing liquidity ratios such as the current, quick, and cash ratios. 

Incorporating liquidity ratios into financial analysis enables stakeholders to make informed decisions and mitigate risk with liquidity challenges.

FAQ’s

What is the difference between solvency and liquidity?

Liquidity refers to a company’s ability to pay short-term bills and debts and sell assets to raise cash; however, solvency refers to a company’s ability to meet long-term debts and continue operations into the future.

Is a high liquidity ratio important? If yes, why?

A high liquidity ratio is important because it makes clearing the debts easier and avoids defaulting on payments.

What are the different types of Solvency Ratio?

The different types of Solvency ratios are like debt-to-asset ratio, interest coverage ratio, equity ratio and debt-to-equity (D/E) ratio.