Liquidity Ratio – Types, Formula, Interpretation, How to Improve it
Liquidity ratios are essential financial metrics that provide insights into a company’s ability to meet its short-term financial obligations and maintain its operations smoothly. These ratios are vital indicators of a company’s financial health and stability. They assess the organization’s liquidity position by comparing its current assets to its current liabilities, shedding light on whether it can quickly convert its assets into cash to cover its debts and upcoming expenses. Let’s learn what liquidity ratio is and how to interpret it.
Content
- What is Liquidity?
- What is the Liquidity Ratio?
- Calculation
- Interpreting the Liquidity Ratio
- Types of Liquidity Ratio
- How To Improve The Liquidity Ratio
- How to Get Immediate Liquidity?
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What is Liquidity?
Liquidity is the quality and ability of an asset to be converted into cash, which denotes the ability of a company or person to meet its financial commitments in the short term. The liquidity ratio is useful for the company’s administration and creditors and suppliers interested in financing it.
Here are a few examples:
- Cash: Cash is the most liquid asset because it’s already in the form of cash and can be used for immediate transactions or to cover expenses.
- Savings Account: Money held in a savings account at a bank is also considered highly liquid. You can withdraw funds from a savings account anytime, although some restrictions or delays may exist.
- Stocks: Publicly traded stocks are relatively liquid because they can be sold on stock exchanges, and the process typically takes only a few days to convert them into cash.
- Real Estate: Real estate, such as a house or commercial property, is less liquid because it may take considerable time to sell the property and complete the transaction.
- Collectables: Items like art, antiques, or rare collectables can be highly illiquid because finding a buyer willing to pay the desired price can take a long time.
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What is the Liquidity Ratio?
The liquidity ratio is a type of financial ratio that determines the ability of a company to pay its short-term obligations. This is mathematically determined and can be presented in percentage or absolute form.
When the company assumes a financial obligation with a third party, such as banks or suppliers, it must be clear about its liquidity capacity to meet that commitment. A series of indicators or indices are used to determine payment capacity. To pay a debt, the company must generate cash; if the debt is short-term, the ability to generate cash must also be short-term. Therefore, the company’s current assets are taken as a reference.
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What liquidity ratios refer to the relationship between a company’s current assets and current liabilities?
- Current assets: Includes cash, accounts receivable, marketable securities, and inventories.
- Current liabilities: Includes accounts payable, notes payable, long-term debt due in the period, taxes payable, and other expenses.
The current liquidity ratios provide information about the company’s ability to face its debts in the short term. Below are the indicators of the liquidity ratios –
- Liquid Assets: Contains cash, gold, excess reserve deposits, net assets after compensation, and bond investments that can be made at any time within the liquidity ratios in national and international secondary markets.
- Liquid Liabilities: Cover demand and time deposits with maturity, net debt after compensation, bonds issued due, interest payable, bank loans, etc.
Calculation of the Liquidity Ratio
The liquidity ratio of assets is the result between liquid assets and liquid liabilities; This gives us the following calculation formula:
Liquidity Ratio = Liquid Assets ÷ Liquid Liabilities × 100%
In the profitability ratios, profit margins are usually used through the financial analysis of the previous indicators. Among these are:
- Net sales margin and gross profit: These indicators show the profits generated by sales revenue.
- Interest rate of the total assets: The indicator of the interest rate of the total assets reflects the integral effect of the net income of the company’s assets.
- Return on Total Assets: This shows the return on equity capital investment.
In this sense, the formula for calculating each indicator to assess the profitability of the company is as follows:
- Net sales margin = Net profit ÷ Sales revenue × 100%
- Gross profit margin = Sales revenue – Cost per sales ÷ Sales revenue × 100%
- Interest rate on total assets = Net profit ÷ Average net assets × 100%
- Return on Total Assets = Net Profit ÷ Average Total Assets × 100%
These indicators are complete and can fully reflect the company’s overall profitability.
Interpreting the Liquidity Ratio
Its interpretation depends a lot on the type of sector and the company’s activity. However, the optimal values of the liquidity ratio are between 1.5 and 2.
- Liquidity ratio less than 1. In that case, it is considered that there is a negative working capital, and this indicates that the company has liquidity problems and, therefore, complications in facing short-term debts.
- Liquidity ratio greater than 1. In that case, the current assets are more significant than the current liabilities, meaning there are no liquidity problems, and the company can meet all its payments without problems. However, if it is much greater than 1, it would be necessary to analyze if the company has excess resources and is not making a profit.
Types of Liquidity Ratio
As we have already mentioned, it is one of the critical indicators that every company’s balance sheet must work on and know to have an accurate idea of the company’s treasury.
Within the liquidity ratios we can find several types of liquidity ratios:
General Liquidity Ratio
This ratio helps calculate the proportion of short-term debt a company can cover with its assets.
The formula to calculate its value is as follows:
General liquidity = Current Assets / Current Liabilities
Acid Test Ratio
The Acid Test Ratio is one of the most exciting and detailed measurements. Calculate the ability of a company to meet its debts in the short term with elements of assets since it subtracts from these elements that are part of the inventory.
The formula to calculate this index:
Acid Test = (Current Assets – Inventory) / Current Liabilities.
Defensive Test Ratio
Through this ratio, it is possible to know the ability of a company to operate in the short term with its most liquid assets without resorting to its sales flows.
Defensive test = (Cash and Banks / Current Liabilities) *100
Working Capital Ratio
This type of financial ratio shows what a company has after paying its immediate debts.
In other words, what the company owns, in the end, to operate.
Working capital = Current Assets – Current Liabilities
Liquidity ratio of accounts receivable
The liquidity ratio of accounts receivable allows you to know the average time the accounts that have not yet been collected can be converted into cash.
Two types of formulas can be used to calculate this –
Average collection period =
(Accounts receivable * days of the year) / Annual checking account sales.
Accounts receivable turnover =
Annual checking account sales / Accounts receivable
How To Improve The Liquidity Ratio
We have explained that a liquidity ratio greater than 1 and precisely a value of 1.5 are indicators of good financial health. But suppose you are still wondering how to improve your company’s liquidity ratio. In that case, you have to know how to achieve a balance and understand two fundamental variables:
- Value of the liquidity ratio you want to improve.
- The objective we want to achieve.
Let’s see with an example how to improve it if our objective is to reach 1.5. We have two assumptions:
Liquidity Ratio Greater Than 1.50
As we have explained previously, in this case, the current assets are more significant than the company’s debts in the short term. To improve it, some options could be:
- Distribute dividends to partners to reduce current assets
- Invest available resources in fixed assets or long-term financial investments to have a return
- Cancel long-term debt
Liquidity Ratio Below 1.50
In this case, the company does not have sufficient liquidity to meet its short-term debts. Increasing current assets and/or decreasing current liabilities is necessary to improve the liquidity ratio. Some alternatives that you can try –
- Negotiate the maturity of debts so that they can be paid in the long term
- Pay off fixed assets or investments to increase current assets
- Make partner contributions to increase current assets.
Immediate liquidity ratio or availability ratio
A company’s treasury grants immediate liquidity and solvency to cover possible short-term debts.
The immediate liquidity ratio analyzes the company’s ability to pay its debts in the short term. Still, it differs in that it only considers the cash on hand that the company has.
The formula is:
Immediate liquidity ratio = Cash / Current Liabilities
The optimal estimated value is between 02.0 and 0.30, although it depends greatly on the activity since the treasury tends to fluctuate considerably.
How to Get Immediate Liquidity?
If you need to know how to obtain immediate liquidity after calculating the liquidity ratio in your company, an agile and effective means is to use external financing or convert the assets into cash through the advance payment of pending collections.
Knowing and interpreting the liquidity ratio correctly according to your business type can give you a significant advantage in controlling your treasury.
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FAQs
What is a good current ratio?
A good current ratio generally falls between 1.5 and 3. A ratio below 1 may indicate liquidity issues, while a ratio above 3 may suggest that a company is not efficiently utilizing its current assets.
What does a high quick ratio indicate?
A high quick ratio suggests that a company has a strong ability to meet its short-term obligations without relying on the sale of inventory. It indicates a higher level of financial stability and liquidity.
How can a low liquidity ratio affect a company?
A low liquidity ratio may indicate a company is facing difficulties meeting its short-term obligations. It could signal financial distress, difficulty in paying debts, or limited access to cash, which may increase the risk of insolvency.
Can liquidity ratios vary across industries?
Yes, liquidity ratios can vary across industries due to differences in business models, capital requirements, and inventory turnover rates. It is essential to compare a company's liquidity ratios with its industry peers for meaningful analysis.
What are some limitations of liquidity ratios?
Liquidity ratios provide insights into a company's short-term liquidity position but do not consider long-term solvency or profitability. Additionally, liquidity ratios rely on the accuracy of financial statements, and they may not capture qualitative factors that can impact liquidity, such as management effectiveness or market conditions.
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