Liquidity ratios measure the firm ability to meet its short term debts as they become due. In other words, they tell how quickly a firm can convert its current assets into cash in order to pay off its short term liabilities. The higher the ratio, the better the position of a firm to pay off its short term obligations. The liquidity ratio affects the credibility of a firm as well as the credit rating of the firm. Usually, the liquidity ratio is used by the creditors (lenders) when deciding whether to extend credit to a business.
What are Types of Liquidity Ratios?
The liquidity of a business can measured through the following ratios. These ratios assess the overall health of a business. These ratios are generally grouped together by financial analyst when measuring the liquidity of a company.
1. Current ratio
2. Quick ratio
3. Working capital
One of the first steps in liquidity analysis is to determine the firm’s current ratio. The current ratio indicates how many times over the company can pay its current debt obligations. In other words, the current ratio shows company’s ability to pay off its current debts over the next 12 months. This means that with the larger amount of current assets the company will more easily be able to pay off its current liabilities. The calculation of current ratio is to divide current assets by current liabilities. For example the current assets are Rs. 600 and the current liabilities are Rs. 300. The current ratio would be:
Current ratio = current assets / current liabilities
Current ratio = 600 / 300
Current ratio = 2
This means that the company can meet its current obligations 2 times. In order to be solvent, the company must have a current ratio of at least 1.0 X. in this case the company can meet its current obligations and have a left over. So, the company is solvent.
A higher current ratio is always more favorable than lower current ratio because it indicates the firm can more easily pay off its current liabilities.
Quick Ratio (Acid Test Ratio)
The quick ratio is the hard test of liquidity than the current ratio. It determines how the firm can pay off its short term liabilities without selling its inventory. It means the quick ratio does not include firm’s inventory as a current asset. The firm uses the quick ratio when they need to pay off short term liabilities within 90 days. The quick ratio is calculated by dividing quick assets (cash + account receivable + marketable securities) by current liabilities. For example, the quick assets are Rs. 250 and the current liabilities are Rs. 300. The quick ratio would be:
Quick ratio = Quick assets / current liabilities
Quick ratio = 250 / 300
Quick ratio = 0.833
This means that the company cannot pay off its current liabilities because the quick ratio is 0.833 which is less than 1. In order to be solvent, the quick ratio must be at least 1 which is not in this case.
If the difference between quick ratio and current ratio is large. This means that the firm is currently relying too much on inventory.
Working capital is the difference between current assets and current liabilities. In simple words, it is available money to fund a company’s day to day business expenses. Increasing current assets lead to increase working capital and it is healthy when working capital is positive. The working capital can be calculated by excluding current liabilities from current assets. For example, the current assets are Rs. 600 and the current liabilities are Rs. 400. The working capital would be:
Working capital = Current assets - current liabilities
Working capital = 600 - 400
Working capital = 200
From the above calculation we have positive working capital which means the company is able to meet its day to day business operations. Lack of working capital suffers business from growing.
For the analysis of a company, it is better to have at least two years of data which provides information on the trend in the ratios.