Wondering what is liquidity ratio?
Simply put, it is a metric that helps understand a company’s ability to pay off short-term debt. It is helpful to estimate whether a company’s current assets can cover its liabilities. It is largely used by banks and other financial institutions to determine whether they can extend credit to a business.
Importance of liquidity ratio
A liquidity ratio can guide businesses on their ability to repay debt and help them plan better. In addition, it plays a significant role in other situations.
It helps determine whether short-term obligations can be met
Investors and creditors alike are likely to have a keen eye for the liquidity ratio of a business because it helps them ascertain whether an extension of credit is viable.
A ratio of one is good but it isn’t always ideal. A higher ratio, perhaps of two or three, is what banks prefer to see because that means that a business can cover its liabilities sufficiently well.
It helps estimate the creditworthiness of a company
When lending to a company, creditors look at its liquidity ratio as a symbol of its creditworthiness.
It is imperative that the company can back the debt it borrows, and the liquidity ratio is a good yardstick to learn that.
It helps understand whether funds can be invested in a company
A company with a good liquidity ratio of more than one is considered healthy and investment worthy. However, a high liquidity ratio, say 9%, is a problem because that means the company holds too much idle cash, which can be put to use elsewhere.
At the end of the day, a company should be able to cover for liabilities and other bills, and at the same time, allocate its capital in a manner that can increase its value to its shareholders.
It helps identify a company’s operational efficiency
If you are to understand the inventory turnover of a company, this ratio can serve as a good benchmark.
It helps to gauge how well a company sells off its inventory for cash and helps companies plan their production of goods, storage of inventory, and preparation for any overhead expenses.
It helps optimize management
The management of a company plays a significant role in its financial health. So, a financial metric like a liquidity ratio can help companies enhance management efficiency to keep up with creditors.
Types of liquidity ratios
As you already know, a liquidity ratio of more than one translates into good financial health.
Let’s look at the different types of liquidity ratios. There is a liquidity ratio formula for each of these.
The quick ratio is also referred to as the acid-test ratio and is arguably the best way to measure the liquidity of a company. The explanation behind this lies in the formula used to calculate the quick ratio.
Only short-term assets that can be easily converted into cash in less than 90 days or are already being held as cash are considered when calculating the quick ratio. A ratio of 1:1 (assets to liabilities) is generally held to be an ideal quick ratio.
Quick Ratio Formula: Quick Ratio = Quick Assets/Current liability where,
Quick Assets = Current Assets – Inventory – Prepaid Expenses or,
Quick Ratio = (Marketable Securities + Available Cash and/or Equivalent of Cash + Accounts Receivable) / Current Liabilities
ExampleParticulars Amount (Crores) Market securities 12,000 Cash and equivalent 68,000 Accounts receivable 7,500 Inventory 20,000 Current assets 1,07,500 Current liabilities 55,000 Quick ratio (12,000+68,000+7,500)/55,000 = 1.6 or (1,07,500-20,000)/55,000 = 1.6
The current ratio is also known as the working capital ratio. It measures your current assets like cash, receivables, prepaid expenditures, and others against your current liabilities like short-term loans, to determine whether the company can pay them off.
Current Ratio Formula: Current ratio = Current assets/Current liabilities
Current assets = 420 crores
Current liabilities = 210 crores
Current ratio = 420 crores/210 crores = 2
A ratio of 2:1 is considered healthy for a company.
The cash ratio tells you how well a company can pay off its current liabilities using cash and other equivalent instruments (treasury bills, marketable instruments, and others).
Other assets that are not held as cash must not be included to calculate this ratio.
Cash Ratio Formula: Cash ratio = Cash and cash equivalents/Current liabilities
Cash and cash equivalent = 900 crore
Current liabilities = 470 crore
Cash ratio = 900 crore/470 crore = 1.91
Absolute Liquidity Ratio
Creditors use this ratio to understand the total liquidity of the company. For the purposes of this ratio, only cash, and marketable securities of the company can be included.
Absolute Liquidity Ratio Formula: Absolute liquidity ratio = (Cash + marketable securities)/ Current liabilities
Cash = 600 crores
Marketable securities = 1500 crores
Current liabilities = 2000 crores
Absolute liquidity ratio = 600 crores + 1500 crores/2000 crores = 1.05
Basic Defence Ratio
Through this ratio, a lender can determine how far a company can handle its cash expenses with no financial help from outside. It is also known by the name defensive interval period.
Basic Defence Ratio Formula:
Basic defence ratio = Cash and equivalent + marketable securities + receivable/ daily operational expenses
Daily operational expenses = (annual operational costs – noncash expenses)/365
ExampleParticulars Amount (in crores) Cash and equivalent 1,15,000 Marketable securities 45,000 Accounts receivable 70,000 Current liquid assets 2,30,000 Daily operational expenses Amount Annual operating costs 6,00,000 Non-cash expenses 80,000 Daily operational expenses 6,00,000-80,000/365 = 1,424 Basic defence ratio 2,30,000/1,424 = 161
Basic Liquidity Ratio
Unlike the other liquidity ratio, the basic liquidity ratio does not pertain to a company.
Instead, it is a personal finance ratio that determines the length of time that a family individual can take care of itself with its liquid assets.
Basic Liquidity Ratio Formula: Basic liquidity ratio= Monetary assets/Monthly expenses
Monetary assets = 500000
Monthly expenses = 250000
Basic liquidity ratio = 500000/250000 = 2
Apart from these, there is the liquidity coverage ratio that reflects the proportion of highly liquid assets that financial institutions like banks and others hold to ensure their capability to meet short-run obligations.
Understanding a good liquidity ratio
Understanding the different formulas and liquidity ratio examples can have several benefits.
It will not only help you identify your company’s current financial health but also serve as a good measure of what is to be done to offset a deficit if any.
As we discussed earlier, a good liquidity ratio is anything that goes north of one. However, in most cases, it is insufficient to prove the creditworthiness and the investment worthiness of your business.
Several creditors and investors look for an accounting liquidity ratio that hovers around two or three.
Naturally, a higher liquidity ratio spells a healthier margin of safety as far as your ability to pay off debts and other obligations is concerned.
However, it isn’t always a good thing. For instance, if your liquidity ratio is too high then investors might wonder what you’re doing with excess cash. It questions the company’s intentions to grow and its focus on profits.
Instead of holding too much cash in hand, it is more profitable to allocate your capital to other initiatives and investments.
The complete picture may not be presented if you were to look at just the liquidity ratio separately. It needs to be combined with other financial metrics and compared with ratios over a period to understand the trend that your company has been following in terms of financial health.
If your liquidity ratios are volatile, then your company may be looked at as operationally risky and financially unstable.
Frequently Asked Questions (FAQs)
Are solvency and liquidity the same? If not, how are they different?
No, they are not the same. Liquidity is a measure that assesses the company’s assets to cover its short-term debt.
On the other hand, solvency is the ability of a company to pay off its total debt while continuing to be in business. To understand the solvency of a company, its liquidity needs to be considered.
What is the ideal current ratio?
An ideal current ratio is anything more than one. A higher current ratio is an indicator of a good financial position.
However, please note that a high accounting liquidity ratio is not necessarily a good thing.
What is meant by SLR?
According to certain guidelines set by the RBI, a business (a commercial bank) must hold a minimum percentage of certain assets such as government securities, cash, gold, and others.
This percentage is referred to as the Statutory Liquidity Ratio or SLR.
What is the most liquid asset?
The most liquid asset in the world is cash. If a business or a company holds a good reserve of cash, liquidity ratios are consequently higher.
In other words, the business is in a good position to pay short-term financial debt with no support from the outside.
However, a very high reserve of cash means that the business has poorly allocated capital and that might raise concerns in a few creditors.
This is a companion discussion topic for the original entry at https://jupiter.money/resources/understanding-liquidity-ratio/