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What is liquidity ratio?
What’s essential to know about liquidity ratio?
In this article, I will break down the meaning of Liquidity Ratio so you know all there is to know about it!
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What Is Liquidity Ratio
A liquidity ratio is a type of ratio that allows you to determine how well a company can pay for its debt without having to use external funding sources.
In other words, liquidity ratios are financial metrics allowing you to assess if the company can generate enough cash or has sufficient liquid reserves to pay for its debt obligations.
The main liquidity ratios are the current ratio, quick ratio, days sales outstanding, and the operating cash flow ratio.
Liquidity is an important concept in business as it refers to the company’s ability to convert its assets to cash.
Every company should find the right balance between having enough liquidity to cover its debt obligations and finance business operations and growth.
In business, the term liquidity refers to a company’s ability to convert its assets to cash.
The more an asset is liquid, the faster it can be converted to cash.
For example, cash in the bank is the most liquid type of asset as it can be immediately used to fund business operations.
Marketable securities are highly liquid as the company can sell them in the open market and realize the cash in a matter of days.
On the other hand, real estate properties and land may not be as liquid as it can take months or even years to sell them to realize the cash.
Investors and financial analysts will typically look at a company’s liquidity ratios to assess the company’s overall solvency and financial health.
When a company is generating enough revenues, has good working capital, has a good level of current assets, and has retained earnings, the company is financially in a good position to scale and grow.
On the other hand, when the company’s liquidity ratios show that the company may not have enough to cover its debt, investors, shareholders, and stakeholders should take notice and assess why it is the case and evaluate the potential default risk and solvency issues.
Why Liquidity Ratios Are Important
Liquidity ratios are very important as you can use them to evaluate how well a company can convert its assets into cash.
When you analyze a company’s liquidity ratios, you are able to get a better understanding of the company’s ability to cover its short-term debt obligations using its assets.
A company can use different liquidity ratios to assess its own performance over the course of different accounting periods.
For instance, if a company notices that its liquidity is degrading over time or that it has too much liquidity, it can immediately take proper measures to remedy the situation.
You can also use liquidity ratios to assess how well you are doing compared to your peers in the same industry or sector.
The analysis of your competitors’ liquidity ratios will help you determine if you are carrying too much liquid assets, if you’re on par, or if you are not carrying enough.
Ultimately, liquidity ratios are critical to every business as they allow you to see how well you are able to quickly and cheaply convert your assets to cash allowing you to cover your debt obligations.
Liquidity Ratio Formulas
There are several key liquidity ratios that are highly used in business.
The first ratio is the current ratio.
The current ratio measures how well a company can use its current assets to pay for its current liabilities.
In other words, if you take the company’s cash, accounts receivables, and inventory, will that be able to pay off the company’s liabilities that are due within a year.
The current ratio formula is:
Current Ratio = Current Assets / Current Liabilities
The second liquidity ratio is the quick ratio, also known as the acid test ratio.
The quick ratio is similar to the current ratio but is more conservative.
In other words, the quick ratio will only consider the company’s most liquid current assets and excludes inventories.
This means that if you add up the company’s cash, marketable securities, and account receivables, do you have enough to pay off the liabilities due within a year period.
The quick ratio formula is:
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
Days Sales Outstanding
Days sales outstanding is another liquidity ratio that is important to consider.
You are essentially calculating the average number of days it takes for a company to get paid after it sells its goods and services to its customers.
The faster a company is able to collect, the better it is for its liquidity.
The days sales outstanding formula is:
Days Sales Oustanding = Average Accounts Receivables / Revenue Per Day
Operating Cash Flow Ratio
The operating cash flow ratio is a liquidity ratio that measures the number of times a company is able to pay off its current debt with the cash it generates from its operations.
The more a company is able to generate cash flows, the more it will be able to cover its debt obligations.
The operating cash flow formula is:
Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
The cash ratio is another liquidity ratio measuring the company’s ability to use its cash and cash equivalents to pay for its current liabilities.
The cash ratio formula is:
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
Liquidity Ratio Interpretation
Liquidity ratios are highly useful in analyzing a company’s financial health and liquidity.
When you look at a company’s liquidity ratios, you can see if the company is generating enough cash from its business operations to be able to pay for its debt.
Many see the use of debt as beneficial to a business as you are essentially using someone else’s money to make money.
Also, the cost of capital for debt tends to be lower than other sources of capital.
However, taking on too much debt can also lead to a liquidity crisis and increase a company’s chances of defaulting on its debt if market conditions change.
As a result, the regular assessment of a company’s liquidity profile is useful to see if the company is keeping steady, doing better, or not.
The interpretation of the liquidity ratios should be done holistically as each ratio can provide valuable insights in a company’s liquidity without being being able to tell the whole story.
Comparing a company’s liquidity ratios over time and comparing companies within an industry can provide key insights into the company’s own liquidity trend and how it compares to the industry.
Liquidity Ratios vs Solvency Ratios
What is the difference between liquidity ratios and solvency ratios?
Liquidity ratios are different financial ratios allowing you to assess how the company is able to pay for its short-term obligations.
Short-term debt is considered any debt obligation that is due and payable within one year.
As a result, liquidity ratios evaluate how well the company can pay for its short-term debt without using any external sources of funding.
On the other hand, solvency ratios are a set of ratios allowing you to assess how well the company is able to pay for its debt on a more long-term basis.
This means that solvency ratios tend to look at all of a company’s assets along with its total liabilities.
The idea is to see if the company’s total assets are enough to theoretically pay off all its liabilities.
Solvency ratios include interest coverage ratio, debt-to-asset ratio, equity ratio, and debt-to-equity ratio.
Liquidity Ratio FAQ
What does liquidity ratio mean?
A liquidity ratio is a type of financial measure allowing you to see how well a company can pay for its short-term liabilities.
The idea is to see if the company has enough current assets to cover its current liabilities.
Current assets are assets that are available to the company within a year and current liabilities are debt obligations payable within a year.
What is the difference between liquidity ratio and solvency ratio?
Liquidity ratios measure a company’s ability to use its current assets to pay for its current obligations.
On the other hand, solvency ratios look at a company’s total asset position to assess how well it can pay for all of its liabilities.
What are the four liquidity ratios?
There are many liquidity ratios.
The four main liquidity ratios that are generally used are current ratio, quick ratio, days sales outstanding, and operating cash flow ratio.
What is a good liquidity ratio?
There’s no cookie-cutter answer as to what is a good liquidity ratio.
A company should have enough liquidity to pay for its current liabilities and enough to reinvest in the business to fund its operations and growth.
Typically, anything that is over 1 is considered acceptable.
However, it’s important to consider the company’s liquidity trend over time, compare it with its peers, and see if the market conditions require a company to have more liquidity or not.
So there you have it folks!
What are liquidity ratios?
In a nutshell, a “liquidity ratio” is a financial ratio used to measure a company’s ability to pay off its short-term financial obligations with its current assets.
Calculating a company’s liquidity is important as you can assess its overall financial health, creditworthiness, risk profile, and, ultimately, the company’s performance.
In this post, I’ve covered five key liquidity ratios: current ratio, quick ratio, days sales outstanding, operating cash flow ratio, and cash ratio.
Other liquidity ratios can be used, such as a company’s net debt, net working capital as a percentage of revenue, absolute liquid ratio, and more, depending on your specific needs.
Now that you know what liquidity ratio is, how to calculate it, and why it matters, good luck with your research!
I hope you enjoyed this article on Liquidity Ratio! Be sure to check out more articles on my blog. Enjoy!
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