Liquidity ratio is a set of ratios that are used to measure the capability of paying off the short term or long term debt obligations of a company. In general, the larger the ratio, the stronger will be the capabilities (except some exceptions) to pay the debt off. Fundamental analysts calculate and interpret liquidity ratios to know the current debt dealing capabilities of a company.
Liquidity Ratios
What is Liquidity Ratio?
Liquidity ratios measure two things. One is the capabilities to pay a short-term debt, and another is the capabilities to pay off the long-term debt. But what does it mean? It means if a company has short term and long term due, the ratio will be showing the capability of paying it back to the debt holders. These ratios, also, show the current position of the cash, investment assets, and inventory level of the company.
It does not only show the current position of paying ability but, also, it shows the borrowing ability of the company. On other words, by seeing these ratios, an analyst can easily understand how much borrowing capability a company has.
Types of Liquidity Ratios
Liquidity Ratios consist of Current Ratio (Also known as Working Capital Ratio), Quick Ratio (Also known as Acid Test), Operating Cash Flow Ratios, and solvency ratio. The current ratio tells a company’s ability to pay off the debt obligations. The quick ratio, also known as the acid test, is used for the same purpose as the current ratio. The key difference is that Quick Ratio does not take inventories into account. That means, it only takes cash and cash equivalent assets like short-term investment securities to calculate Quick Ratio. Operating Cash Flow Ratio shows how much strength a company has to cover all of its current liabilities by the cash flow generated by the company’s operations.
Interpretation and Analysis of Liquidity Ratios elaborate
There are a few ways to interpret and compare the liquidity ratio. Also, for some cases, it’s subjective to the type of business. For most of the cases, there will be benchmarks against which financial ratios are compared. For example, the benchmark for the current ratio is 1. Below one is treated as a bad condition and above one is treated as a better condition. And again, it is subjective to the business type. I have discussed it in the individual ratio section in detail.
When comparing with the industry average, the ratio average is calculated at first. Then individual company ration is compared with the respective industry average.
When comparing with another company, a company from the same industry is taken. Then the target company’s ratio is calculated with the chosen one.
Advantages of Using Liquidity Ratios Analysis elaborate
- It helps to get an idea on the liquidity position of the company.
- It shows how a current asset-rich company is it.
- It shows how much debt you can pay off only using the cash on hand.
- It helps to understand the strength of the company.
- It shows how quickly a company can pay off its debt.
- It helps to understand how quickly a company can convert its inventories into cash.
- It helps to understand how much cash/current asset you will need if the company is in deficit.
- It shows how much ideal money you have on your hand.
- It shows how much current asset you are utilizing properly.
- It shows how much inventories you are keeping in your storage.
Disadvantages or Limitations of Using Liquidity Ratios Analysis
- Using the ratio standalone will not be a great idea.
- Different companies are from different industries. So, the ratio of one company will not be comparable with other from another industry.
- The value of the Ratios may vary because of accounting standards/evaluation methods of inventories.
- The value of inventories changes over time, so ratio may change as well.
- Ratios are calculated from the past data while analyst will have to decide for the future.
Financial Accounts used to calculate Liquidity Ratios
The financial accounts used to calculate liquidity ratios are current assets, current liabilities (inventories, marketable securities, accounts receivables), cash flow from operations, total debt, total equity, operating income (or EBIT), and interest expense.
Key Things to Remember While Using Liquidity Ratios elaborate
- Must choose companies from the same industry.
- Must conduct time series as well as cross-analysis.
- It is valid only for 12 months.
Sheikh Faizul Haque is an internet entrepreneur and the founder of The Strategy Watch; Graduated from North South University with a double major in Accounting & Finance in Bangladesh.
With a strong interest in developing and improving Business Strategy and to Conduct Business Analysis.