What is a Liquidity Ratio?
A liquidity ratio is a type of financial ratio that is used to determine a company’s ability to pay off its short-term obligations/debt. It helps determine if a company can use its current or liquid assets to cover its current liabilities. There are three commonly used ratios: the current ratio, quick ratio, and the cash ratio. In each of the liquidity ratios, the current liabilities amount is placed in the denominator of the equation, and the amount of the liquid assets are placed in the numerator. A ratio of 1 means that a company can exactly pay off all its current liabilities with its current assets. A ratio of less than 1 would imply that the company is not able to satisfy its current liabilities. A ratio greater than 1, say 3, would imply that a company is able to satisfy the current liabilities 3 times over.
Types of Liquidity Ratios
Current ratio = Current Assets / Current Liabilities
The current ratio is the simplest liquidity ratio to calculate and interpret.
Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities
The quick ratio is a stricter test of liquidity than the current ratio. However, the quick ratio only considers certain assets. It considers more liquid assets such as cash, accounts receivable, and marketable securities. It leaves out current assets such as inventory and prepaid expenses because the two are less liquid. So, the quick ratio is more of a true test of a company’s ability to cover its short-term obligations.
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
The cash ratio takes the test of liquidity even further. This ratio only considers a company’s most liquid assets – cash and marketable securities. They are the assets that are most readily available to a company to pay short-term obligations.
Importance of Liquidity Ratios
- Determine the ability to cover short-term obligations:
Liquidity ratios are important to investors and creditors to determine if a company can cover their short-term obligations, and to what degree. A ratio of 1 is better than a ratio of less than 1, but it isn’t ideal. Creditors and investors like to see higher liquidity ratios, such as 2 or 3. The higher the ratio is, the more likely a company is able to pay its short-term bills. A ratio of less than 1 means the company faces a negative working capital and can be experiencing a liquidity crisis.
- Determine creditworthiness:
Creditors analyze liquidity ratios when deciding whether or not they should extend credit to a company. They want to be sure that the company they lend to has the ability to pay them back. Any hint of financial instability may disqualify a company from obtaining loans.
- Determine investment opportunities:
For investors, they will analyse a company using liquidity ratios to ensure that a company is financially healthy and worthy of its investment. Working capital issues will put restraints on the rest of the business as well. A company needs to be able to pay its short-term bills with some leeway.
Use of Liquidty Ratios in Practice
It is one thing to know the ratios and quite another to actually use it in real life. A good example of using liquidty ratios would be to screen stocks to research further. For example if go to https://www.screener.in/screens/ and try to find company based on the the following quality characteristic given by benjamin graham
- Current ratio is greater than 1.25 (it signifies that the company has the ability to pay off short term expenses
- Check out the companies that turn up when we use this liquidity screen.