Liquidity Ratio

What is a Liquidity Ratio?

A liquidity ratio is a financial parameter used to assess a company's capacity to fulfil its short-term loan commitments. The indicator determines whether a company's current, or liquid, assets can pay its current obligations. The current, cash and quick ratios are the three most widely utilised liquidity ratios. 

The quantity of current obligations is put in the denominator of each liquidity ratio, while the amount of liquid assets is put in the numerator. Ratios greater than 1.0 are desired due to the structure of the balance, which places assets on top and liabilities on the bottom. 

A ratio of one indicates that a company's current assets are sufficient to cover all of its current obligations. A ratio of less than one indicates that a corporation is unable to meet its present liabilities. A ratio larger than one indicates that a corporation can pay its existing debts. In essence, a ratio of 2.0 indicates that a company's existing liabilities may be covered twice over. A ratio of 3.0 indicates that their existing liabilities might be covered 3 times more, and so on.

Comparative applications of liquidity ratios are the most useful. Analysts may perform internal and external analyses. An internal study of liquidity ratios, for example, requires the use of various accounting periods, which are presented using the same accounting procedures. By contrasting previous years with current activities, analysts may monitor changes inside the company. 

An organisation is generally deemed more liquid and has greater coverage of its outstanding obligations when its liquidity ratio is higher. External analysis, on the other hand, entails evaluating the liquidity ratios of one business against another or an entire industry. When creating benchmark targets, this information may be used to evaluate the company's strategic stance to that of its rivals. 

When examining across sectors, liquidity ratio research may not be as helpful since different firms demand different funding arrangements. When comparing enterprises of various sizes in different geographical areas, liquidity ratio evaluation is less useful.
 

Types of Liquidity Ratios

Other factors are considered when determining a company's financial strength using the liquidity ratio formula. Liquidity ratios types that determine the financial strength are:

●    Current Ratio
This ratio assesses the company's financial strength. In general, 2:1 is considered the best ratio, however, it varies per industry.
          
The formula for Current Ratio: Current Assets/Current Liability 

Current assets include stock, debtors, cash in the bank, receivables, loans, advances, and other current assets.

Current liabilities include creditor obligations, short-term loans, bank overdrafts, unpaid costs, and other existing liabilities.

●    Quick Ratio
This ratio is the most accurate and cautious indicator of the company's liquidity. The fast asset is calculated by modifying current assets to exclude assets that are not in cash.

In general, 1:1 is considered an optimal ratio.

The formula for Quick Ratio: Quick Assets/Current Liability 

The quick asset is calculated by subtracting Inventory and Prepaid Expenses from Current Assets.

●    Absolute Liquidity Ratio
This ratio simply accounts for the company's marketable securities and cash reserves. This ratio solely measures short-term liquidity in current investment, funds, and marketable securities,

The formula for Absolute Liquidity Ratio: Cash + Marketable Securities / Current Liability 

●    Basic Defense Ratio 
This ratio calculates the number of days a firm can meet its cash costs without relying on outside finance.

The formula for Basic Defense Ratio:
(Cash + Receivables + Marketable Securities)/(Operating Expenses + Interest + Taxes)/365
 

Importance of Liquidity Ratios

The liquidity ratio is important for the following reasons:

1. Determine the capacity to fulfil short-term obligations
Liquidity ratios help investors and creditors judge if a firm can meet its short-term obligations and to what extent. A ratio of one is preferable to less than one, although it is not optimal. A liquidity ratio of two or three is preferred by creditors and investors. The greater the ratio, the more probable it is that a corporation can pay its short-term expenses. A ratio of less than one indicates that the firm has inadequate working capital and may be suffering a liquidity issue.

2. Assess creditworthiness
Creditors use liquidity measures to determine whether or not to offer credit to a firm. They want to ensure that the firm to whom they lend can repay them. Any indication of financial insecurity may preclude a corporation from acquiring financing.

3. Evaluate the investment's merit
Investors use liquidity measures to assess organisations and decide if they are financially stable and deserving of their capital. Working capital constraints will also have an impact on the remainder of the firm. A company must have the financial flexibility to cover its immediate obligations.

Low liquidity ratios are a red flag, but the adage "the greater, the better" is only accurate to a point. Investors may at some time wonder why a firm has such high liquidity ratios. A business with a liquidity ratio of 8.0 will undoubtedly be able to meet its short-term obligations, but investors could find that to be excessive. A high ratio indicates that the firm has a substantial quantity of liquid assets. 

Example: Investors and analysts can view a company's cash ratio of 8.0, for instance, as being excessively high. The amount of cash the firm has on hand is excessive, and it is only earning the interest that the bank gives to store its cash. It might be argued that the funds should be allocated to other activities and investments that would yield a larger return. 

Liquidity ratios strike a compromise between a company's ability to securely meet its bills and inefficient capital deployment. Capital should be deployed in the most efficient manner possible to improve the firm's value for shareholders.
 

Limitations of Liquid Ratio

●    Quality is just as important as the number of liquid assets. This ratio simply accounts for a company's current assets. To assess a company's liquidity strength, several accounting criteria should be used in addition to the liquidity ratio.

●    Inventory is used in the liquidity ratio to assess a company's liquidity. However, this might lead to an error owing to overestimation. Higher inventory might also contribute to lower sales. As a result, inventory calculation may not reveal a company's true liquidity.

●    Given that it solely takes into consideration data from the balance sheet, this ratio may potentially be the result of imaginative accounting. Analysts must do liquidity ratio analysis to comprehend an organisation's financial situation outside the information on the balance sheet.
 

Conclusion

A liquidity ratio meaning assesses a company's capacity to meet its financial obligations and is, therefore, a critical type of financial measure. Investors and creditors search for a firm or organisation with a liquidity ratio that is greater than 1.0 when analysing it, therefore, having a high liquidity ratio is essential for any business to attract investors. A company with good liquidity ratios is more likely to be approved for loans.