What is the Liquidity Ratio? Types, Formula & Importance

What is the Liquidity Ratio?

The liquidity ratio is a metric used to assess a company's capacity to pay off debt as it becomes due. This ratio demonstrates how quickly a company can sell its assets and clear its debt.

Every business has some tangible and intangible assets. These assets are owned by the company and are used for several purposes. These are listed on the company's balance sheet according to their value at the end of the fiscal year.

If any debt is owed, businesses can use these assets to pay it off. Therefore, by examining a company's liquidity ratio, you can determine how quickly it can turn its assets into cash and pay off its debt.

Different Types Of Liquidity Ratios

• Current Ratio

This is an easy calculation to find out the current liquidity ratio of a company. This ratio aids in determining the company's current capacity to settle its debt, primarily the debt due within a year. To calculate this ratio, you need to know the company's current liabilities and assets, such as cash, accounts receivable, and inventories. This information is readily available from the company's balance sheet. Once you have both, you can calculate a company's current liquidity ratio by dividing existing assets by current liabilities.

The formula for this will be as follows:

 

• Quick Ratio

A quick ratio is a helpful tool for assessing a company's capacity to meet its immediate obligations. However, it is more complex than the current ratio. To determine this ratio, you must remove less liquid assets from the existing ones. Inventory and prepaid expenses are excluded from the quick ratio calculation because they are less liquid. Due to this, the quick ratio is a tough and accurate indicator of a company's capacity to meet its short-term obligations.

The formula for quick ratio is:

 

Where,

C stands for cash & cash equivalent

MS represents marketable securities

AR stands for accounts receivable

CL represents the current liability

Another way to calculate Quick Ratio is:

 

• Cash Ratio

The most challenging way to assess a company's capacity to settle its short-term debts is through its cash ratio. It makes a company's liquidity test more difficult. Only highly liquid assets that can help the company pay off its debt quickly will be counted as current assets. To calculate a company's cash ratio, inventories, prepaid expenses, and receivables are excluded, leaving only cash and marketable securities.

The cash ratio evaluation formula is as follows:

 

• Basic Defence Ratio

This ratio aids in estimating the number of days a business can operate on the cash it has on hand without any financial assistance from outside funding. In essence, this ratio aids in understanding a company's financial situation. The defensive interval period or basic defense interval is another name for this ratio.

The formula for basic defense ratio:

 

 

The Importance Of The Liquidity Ratio

The liquidity ratio is crucial for determining the company's capacity to pay off the debt shortly. Let's understand the importance of a company's liquidity ratio:

• Analyze the Business's Capacity to Repay Short-term Debt

The liquidity ratio is crucial for creditors and investors to understand the company's capacity to settle short-term debt. It is helpful to gauge the company's ability to pay off its debt in the short term. Investors and creditors can make better decisions about a particular company based on the liquidity ratio.

A company's liquidity ratio shouldn't be less than 1, which indicates it cannot pay off its short-term debt quickly and has fewer current assets. Over 1 or 2 is considered a good liquidity ratio for a company. The ability of a company to pay its short-term obligations is better when the ratio is higher.

• Analyze a Company's Creditworthiness

The liquidity ratio aids in the analysis of the company's ability to recoup its debts by creditors. It helps them in deciding whether to lend money to a business. They can determine whether the company is capable of repaying its debts in the future or not. Creditors may decide not to lend money to a company if it has insufficient current assets on hand or a low liquidity ratio.

• Analyze a Company's Investment Potential

Before investing in a company, investors can also consider the liquidity ratio. Through the liquidity ratio, they can assess the company's financial health.

It is also a good indicator to know if the company is utilizing its capital well or not. For example, high liquidity ratios may be a red flag, even though they demonstrate a company's ability to pay off its debt quickly.

A company with a very high liquidity ratio has a lot of current assets on hand, which is not a wise financial decision. Instead, the company can use that money for other projects and generate a better return.

Therefore, before investing in a company, it is vital to ensure its liquidity ratio is not excessively high or low.

For instance, investors and analysts may deem a liquidity ratio of 8 or 8.5 too high, whereas a liquidity ratio of less than 1 may be considered too low. For a company, a liquidity ratio of 2 or 3 is preferable. Before investing, most investors check this liquidity ratio number.

 Liquidity Ratio vs Solvency Ratio 

Although the solvency and liquidity ratios are two distinct ratios, the liquidity ratio can occasionally help provide insight into a company's solvency ratio. Creditors and investors can use liquidity to assess a company's solvency.

While the liquidity ratio focuses on the company's ability to pay its short-term obligations, the solvency ratio assesses the ability of the company to pay its overall debt obligation and continue operating without interruption.

A company must have more total assets than total liabilities to have better solvency. On the other hand, a company needs to have more current assets than current liabilities to have better liquidity. Both ratios help determine the company's debt-paying capacity. That is the common characteristic between them.

You can divide the company's net income and depreciation by its total liabilities to determine its solvency ratio. You can decide if a company's net income can cover its total liabilities by calculating its solvency ratio. The higher the solvency ratio, the better investment the company considered.

 Example of Liquidity Ratio

Let's use an example to comprehend the liquidity ratio thoroughly. By looking at its liquidity ratio, you can see how creditors and investors assess the company's value. To better understand the liquidity ratio, we'll use a hypothetical example.

The balance sheet of a company:

 

                    = 215,000 / 150,000

                        = 1.43

Quick ratio = (C + MS + AR) / CL

                  = (82,500 + 37,500 + 45,000) / 150,000

                   = 165,000 / 150,000

                   = 1.1

Cash ratio = (Cash + Marketable Securities) / Current Liabilities

                 = (82,500 + 37,500) / 150,000

                 = 120,000 / 150,000

                 = 0.8

 What Are The Limitations Of Liquidity Ratio?

The following are some typical liquidity ratio limitations:

• The quantity of assets is crucial when assessing a company's liquidity, but so is the quality of those assets. However, you can only determine the amount of those assets using this ratio, not the quality. This could limit this ratio, so you must also consider other accounting metrics to determine the precise strength of a company's liquidity.

• Using inventory to calculate the liquidity ratio is required in some formulas, which increases the risk of calculation errors. For example, lower sales during those fiscal years may cause a higher inventory rate. Therefore, relying on inventory to determine a company's liquidity is unjustified.

• One of the main drawbacks of this ratio is that it is based on the company's balance sheet results. Therefore, to evaluate the company's financial position, you must consider other factors besides the balance sheet.

 Bottom Line

Before investing in any company, it is crucial to understand the liquidity ratio. It aids in understanding the company's financial situation and gives you a sense of how liquid the business is. However, there are several other factors you should consider before making your decision, as we always say, since there isn't just one thing you need to look into before investing. Therefore, keep this in mind and take action that will reduce your investment risk. In addition, you can also get assistance and investment advice from Agarwal Corporate.

What are your opinions on the liquidity ratio? Before investing, do you check it? Do share your experiences in the comment section.