Liquidity ratios are an indicator that helps to understand the company’s capacity to honour the existing debt commitments without any external assistance. The liquidity ratio is a crucial accounting technique to assess a borrower’s current loan repayment capabilities. Simply put, this ratio represents whether an individual or business can pay off short-term debts without the aid of outside funds.
Liquidity is the capacity to turn assets into cash rapidly and inexpensively. Liquidity ratios are most beneficial when utilised in a comparative context. We can classify this into Internal and external studies.
- An internal study of liquidity ratios uses the past historical internal data of the company with that of the current period, while the accounting procedures remain the same.
Analysts may monitor changes in the firm by comparing historical periods to present operations. A higher liquidity ratio highlights that the company is more liquid and is better positioned to cover and service its existing loan commitments.
- The external analysis compares a company’s liquidity ratio with other companies or even industry players.
This evaluation helps to compare the data of existing companies with its peer competitors and incorporate a higher standard in liquidity management.
Liquidity ratio analysis will be different for one industry compared to others. Since the ratio requirement will differ for various industries, you cannot compare it with other sectors.
Liquidity ratio analysis also has drawbacks compared with companies of different sizes. The turnover, market cap, and liquidity strategy will be different. A startup company will have a different liquidity strategy than a well-established MNC.
- Liquidity is the ease with which an asset or security may be purchased or sold on the market and converted to cash.
- Liquidity risk is classified into two types: funding liquidity risk and market liquidity risk.
- A corporate treasurer’s primary worry is funding or cash flow liquidity risk, which examines whether the company can fulfil its obligations.
- Asset illiquidity, or the inability to readily exit a position, is a market or asset liquidity risk.
Different Types of Liquidity Ratio and their Formula
The current ratio denotes a company’s ability to meet its current commitments by using its existing assets. Cash, shares, receivables, prepaid expenditures, marketable securities, deposits, and so forth are examples of current assets. Current obligations also include short-term loans, payroll liabilities, unpaid costs, creditors, various other payables, etc.
Current ratio = Current assets/Current liabilities
Current assets of ABC Ltd is 250 crores, and the current liabilities is 150 Crores.
Then, the current ratio will be 250/150 = 2:1
The quick ratio (or acid test ratio) assesses a company’s capacity to satisfy short-term commitments using its most liquid assets, eliminating inventories from current assets. It is also called the acid-test ratio.
Quick ratio = (Marketable securities + available cash and/or equivalent of cash + accounts receivable)/Current liabilities
Financials extract of XYZ Limited:
||Amount in Cr
|Cash and Cash equivalent
|Daily Operational Expenses
|Total Current Assets
|Total Current Liabilities
||Rs. 115/Rs.60 = 1.91
The cash or equivalent ratio compares a company’s most liquid assets to its total current debt, such as cash and cash equivalents. Because money is the most liquid asset, this ratio reveals how fast and to what extent a corporation can repay its existing liabilities using readily accessible assets.
Cash ratio = Cash and equivalent/Current liabilities
Cash ratio calculation from above data of XYZ Limited
Rs. 65/Rs. 60 = 1.08
The absolute liquidity ratio compares marketable securities, cash, and cash equivalents to current obligations. Companies should aim for an absolute liquidity ratio of 0.5 or higher.
Absolute liquidity ratio = [Cash and equivalent + marketable securities]/ Current liabilities
Absolute ratio calculation from above data of XYZ limited:
= (Rs. 65 + Rs. 15 ) / Rs. 60 = 1.33
The basic defence ratio is an accounting indicator that evaluates how many days a corporation can operate on cash costs alone without outside financial assistance.
Basic defence ratio = Current assets/Daily operational expenses
Basic defence ratio calculation from above data of XYZ limited:
= Rs. 160/2 = 80
Unlike the other ratios mentioned above, the basic liquidity ratio has nothing to do with the company’s financial status. Instead, it concerns an individual.
A person’s financial ratio specifies a time frame for how long a family can fund its needs using liquid assets. It is preferable to have at least three months of cash on hand.
Basic liquidity ratio = Monetary assets/Monthly expenses
The Importance of Liquidity Ratios
Ability to cover the debts
Water rates are vital for investors and lenders to judge whether and to what degree a firm can satisfy its short-term commitments. A rating of 1 is better than a rating of less than 1, but it is still not satisfactory. High-interest rates, such as 2% or 3%, are favourable to lenders and investors.
If the rate is high enough, the company will pay off its short-term commitments. A grade of less than one indicates that the firm is incurring excessive operational expenditures and experiencing a cash deficit.
Lenders consider the amount of money when considering whether or not to lend to a company. They want to ensure that the company they are funding can repay them. Any indications of financial insecurity might hinder a corporation from obtaining a loan.
Determine investment feasibility
For investors, stock ratings will determine if the firm is financially solid and worth investing in. Compelling financial issues will place constraints on the rest of the company. The company must pay off its short-term loans by a specific date.
There is a balance in terms of available income between a company that can reliably fulfil its obligations and an unjust cash allocation. The deployment of capital funds should be in the most efficient manner possible to increase the profit of the shareholder company.
Which Is Better: Solvency Ratios or Liquidity Ratios?
In contrast to liquidity ratios, solvency ratios assess a company’s capacity to meet its financial and long-term total obligations. Solvency refers to an enterprise’s total ability to pay creditors and maintain operations. At the same time, liquidity is mainly concerned with short-term financial and current accounts.
When a company’s total assets exceed total liabilities, it is solvent. When its existing assets are more than current liabilities, it is a liquid company. While solvency is not directly related to liquidity, liquidity ratios are a good starting point for determining a company’s solvency.
You can calculate a company’s solvency ratio by dividing its net income and depreciation by its short- and long-term obligations. This ratio demonstrates if a company’s net income can fulfil its total commitments. A corporation with a greater solvency ratio is typically a better investment.
What if a Company’s Ratios Are Not Liquid?
In this case, even robust businesses may face a liquidity crisis. It will be impossible to meet short-term commitments such as credit repayment and payment to employees or suppliers.
The worldwide credit crunch of 2007–09 was one example of a recent extraordinarily severe liquidity crisis. During this crisis, many corporations could not provide short-term financing for their urgent needs.
Mutual Fund Liquidity Ratio
A mutual fund’s cash and cash ratio equals the current assets. In other words, if a mutual fund has a large amount of cash that has not been invested in securities, the ratio is greater. However, the ratio is lower if all or almost all of its liquidity has been invested.
A high ratio is an unusual signal since it indicates that investments with high returns are complex for the Mutual Fund. Hence, higher cash stocks are held. Mutual funds disclose cash ratios once a month.
What Is the Importance of Calculating Liquidity Ratios?
The organisation may wish to calculate and analyse its liquidity ratios for several reasons. A major reason is to ensure that creditors, bankers, shareholders, and other stakeholders do not anticipate a cheap rate due to a bad liquidity ratio.
- The board of directors will also look at these percentages when evaluating executive performance.
- Banks, creditors, and investors primarily review these ratios in their research. You want to know what is best for your company before giving loans or investing in a new fund.
When the percentages are excessively low, these stakeholders generally have strong opinions and are not interested in the entity. That is why a business must ensure that the ratio appears good from time to time.
Why Are There So Many Different Liquidity Ratios?
The liquidity ratio is to assess the company’s capacity of servicing and repayment of its existing loans. The cash ratio considers cash on hand divided by CL. However, the quick ratio includes cash equivalents (such as money market holdings), marketable securities, and accounts receivable. All current assets are taken into consideration for calculating the current ratio.
Which Asset Can Be Classified as the Most Liquid Asset?
Cash is the world’s most liquid asset. A bigger cash holding suggests that a corporation has a higher liquidity ratio. That indicates the organisation is prepared to satisfy any short-term financial obligation without the assistance of outside funds.
Even strong businesses might have a liquidity crisis if conditions make it impossible to satisfy short-term commitments such as loan repayment and employee pay. The global credit crunch of 2007–09 is the finest illustration of such a wide-reaching liquidity disaster in recent memory. Commercial paper, which is short-term debt issued by major corporations to fund current assets and pay off current creditors, played a key part in the financial crisis.
There was a near-total freeze in the 2 trillion commercial paper market in the United States. This move made it very difficult for even the most solvent firms to acquire short-term funding at the time. This aspect hastened the downfall of prominent organisations such as Lehman Brothers and General Motors (GM).
On the other hand, a company-specific liquidity crisis may be remedied simply with a cash injection unless the financial sector is under a credit constraint (as long as the company is solvent). This solution is because the corporation may pledge certain assets to obtain cash through the liquidity crisis. A technically insolvent firm may not choose this path since a liquidity crisis would aggravate its financial predicament and drive it into bankruptcy.
Examples of Liquidity Ratios
Given below are the various liquidity ratios of two different companies. Let us analyse which company has better liquidity.
|Current ratio – 3.0
Quick ratio – 2
Debt-to-Equity ratio – 3.33
Debt-to-Asset ratio – 0.67
|Current ratio – 0.4
Quick ratio – 0.20
Debt-to-Equity ratio – 0.25
Debt-to-Asset ratio – 0.13
These ratios allow us to make numerous inferences regarding the financial health of these two firms.
Tractors Ltd has a very high level of liquidity. According to its current ratio, it has 3 in current assets for every 1 in current liabilities. Even after eliminating inventory, its fast ratio indicates acceptable liquidity, with two assets converted quickly to cash for every 1 in current obligations.
However, financial leverage looks to be highly substantial based on its solvency measures. Debt outweighs equity by more than three times, and debt has funded two-thirds of assets. Consequently, the debt-to-tangible-assets ratio of —0.91 indicates that borrowing has supported more than 90% of tangible assets (plant, equipment, and inventory, for example).
Therefore, Tractors Ltd has a healthy liquidity position but a dangerously high level of debt.
Cars Ltd finds itself in a new situation. With just 0.40 of current assets available to pay every 1 of existing obligations, the company’s current ratio of 0.4 shows an insufficient level of liquidity. The quick ratio reflects an even more catastrophic liquidity situation with just 0.20 of liquid assets for the daily obligation.
On the other hand, financial leverage looks reasonable, with debt accounting for just 25% of equity and debt financing only 13% of assets. Overall, Cars Ltd is in a problematic liquidity condition, although it is well-capitalised.
Here are the key takeaways from this article:
- You may need to include several additional Liquidity Ratios in your ratios study depending on the sectors and other areas in which your firm operates.
- It may be necessary to relate your ratio with expectations, industry research, and/or rivals to make it speakable. Aside from looking at cash flow, you must also consider additional non-financial elements.
- In contrast, you may efficiently address a company-specific liquidity crisis with a capital injection unless the banking system is experiencing credit constraints.