Liquidity Ratio

Accounting metrics used to determine a debtor's ability to pay off short-term debt without raising external capital.

Generally speaking, liquidity pertains to how easily an asset can be transformed into cash without disrupting the market price. Therefore cash is the most liquid asset a business can have. If markets are not liquid, selling or converting assets or securities into cash becomes difficult.

In comparison, an asset with lower liquidity would be something that would be difficult to convert cash, such as factories, lands, machinery, etc.

Liquidity ratios are accounting metrics used to determine a debtor's ability to pay off short-term debt without raising external capital. 

The use of these metrics helps evaluate whether a firm can cover its current liabilities with its current assets.

The three most common types of these metrics include the current ratio, the quick ratio, and the cash ratio. 

Net working capital is also indicative of a firm's liquidity, net working capital is the firm's current assets minus its current liabilities, and a high working capital means that the company can easily meet its short-term financial needs. 

A firm with a large volume of inventory that is difficult to sell may have a high volume of net working capital and a current sound ratio but may have little liquidity. 

The account receivable and inventory turnover ratios are good metrics for evaluating a company's liquidity. 

Calculating liquidity ratios

The ratio indicates the ability of the business to pay off its short-term loans without the need to raise external capital, such as via the selling of assets.

It measures the firm's liquidity, which is the ability to swiftly swap assets for cash. 

Calculating these ratios also helps measure the margin of safety. Three different formulas can be used to calculate liquidity - the current ratio, the quick ratio, and the cash ratio.

Financial metrics are indicative of a company's financial performance, financial position, and financial strength. For example, Liquidity ratios fall into a class of financial metrics called Cash Flow Metrics.

This category of financial metrics is calculated to evaluate how the business is performing in liquidity, return on investment, or discounting impact.

The three main metrics used to calculate a company's liquidity are the current ratio, the quick ratio, the cash ratio, the cash conversion cycle, and the defensive interval ratio.

This is an important part that creditors check before entering into short-term loan contracts with the company. A business that cannot pay its dues impacts its creditworthiness and adversely affects the company's credit rating.

types

Liquidity ratios are accounting metrics used to determine a debtor's ability to pay off short-term debt without raising external capital. 

The use of these metrics helps evaluate whether a firm can cover its current liabilities with its current assets.

The three most common types of these metrics include the current ratio, the quick ratio, and the cash ratio. 

1. Current ratio

The current ratio is a ratio used to calculate a company's ability to pay a debt due within a year.

It tells investors, decision-makers, managers, and analysts how a firm can optimize current assets on financial statements to satisfy its existing debt and other expenses.

Generally, a current ratio that is in tune with or greater than the industry average is desired.

Current ratio = Current Assets/ Current Liabilities

Current assets are highly liquid assets such as cash, inventory, and accounts receivables. 

Current liabilities are liabilities a company has to pay off in the short term, such as accounts receivables, bank overdrafts, etc.

A good position depends on the industry average, but a current ratio between 1.5 and 3 is a good place to be.

The main difference between the current and quick ratios is that the quick ratio excludes existing assets, such as inventory, as they cannot be as easily converted to cash.

2. Acid test ratio

The acid test ratio is sometimes also called the quick ratio. The quick ratio is similar to the current ratio as both are the ratio of existing assets to current liabilities.

However, the quick ratio is more selective with the numerator and only accepts highly liquid current assets such as cash, cash equivalents, inventory, and accounts receivables.

Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable)/ Current Liabilities

Although the current and acid test ratios evaluate a firm's liquidity, there is a subtle difference between them. The current ratio is a more aggressive estimate as it encompasses more items.

A positive number on the acid test ratio is typically seen as favorable; however, cases might vary. A quick ratio greater than one can indicate the company's ability to survive emergencies or other events that create temporary bottlenecks in cash flow.

3. Cash Conversion Cycle

The cash conversion cycle (CCC) is an accounting metric that illustrates the duration it takes a firm to convert cash and cash equivalents into stock and then back into cash in the form of revenue.

The smaller the CCC, the better the company's position in terms of liquidity. 

The first part of the formula is days inventory outstanding or DIO. This is a working capital management ratio that calculates the mean number of days a firm holds stock before turning it into revenue. A build-up of stock would cause a less desirable CCC.

The CCC can be evaluated using the following formula:

CCC = DIO + DSO - DPO

The formulas define the DIO, DSO, and DPO:

Formulas

4. Cash Ratio

This ratio is the most conservative measure of liquidity. The cash ratio is even stricter than the quick ratio as it only accounts for cash and cash equivalents in the numerator. 

Cash Ratio = cash + Cash Equivalents/ Total Current Liabilities

Cash and cash equivalents are perceived as the most liquid assets a business entity can hold, so the ratio of cash and cash equivalents to current liabilities can be used as a strong projection of a company's liquidity.

A cash ratio of 1 or higher is seen to be good.

5. Defensive Interval Ratio

A defensive interval ratio, sometimes called DIR, is a financial metric that quantifies the financial stability of a firm. 

In particular, the metric tells us how long a company can sustain its operation with its current assets, given that there is no extra cash flowing in.

Defensive Interval Ratio = Cash + Securities + Account Receivable/ Daily Cash Expenditure

The defensive interval ratio is crucial in determining a business entity's financial strength as it clearly shows the company's liquidity position.

The metric illustrates the specific days the company can run without selling its non-current assets. 

This makes a metric much easier to understand than metrics without units, such as the current cash ratio.

 $
Cash2188
Short Term Investment65
Accounts Receivable1072
Inventory8338
Other Current Assets254
Total Current Assets11917
Accounts Payable4560
Outstanding Expenses1943
Tax Payable534
Deferred Revenue998
Total Current Liabilities8035

Example of liquid ratio analysis

To illustrate the use of these financial metrics, we take a company named "The Spacing Guild." The details of their short-term assets and liabilities are shown in the table above.

Current ratio = Current Assets/ Current Liabilities

Current Ratio = 11917/ 8035 = 1.48x

A larger current ratio is better for the firm's liquidity. A healthy current ratio is between 1.2 to 2, which means that the firm has twice the financial value of current assets than liabilities. The Spacing Guild has a current ratio of 1.48, considered healthy.

A current ratio smaller than one means the business doesn't have sufficient liquid assets to cover its debts. 

Quick ratio = (Current Assets - Stock)/ Current Liabilities = 0.45x

Companies with a quick ratio smaller than one do not have enough liquid assets to cover short-term liabilities. In this case, the quick ratio is 0.45, meaning that the company might be relying too heavily on the stock.

Defensive Interval Ratio = (Cash + Securities + Receivables)/ Daily Cash Expenditure/ 365 = 92.27

In contrast to the other metrics used for this example, the defensive ratio is more straightforward to interpret. Generally speaking, the higher this number, the better the firm's financial health in terms of paying off current debts.

Cash Ratio = (Cash+ Securities)/ Total Current Liability = 0.28

If the cash ratio is 1, the business has the exact amount of cash and cash equivalents to cover current liabilities. Conversely, If the cash ratio is smaller than 1, there's insufficient cash. In this case, it is 0.28, indicative of poor liquidity.

Why is liquidity important to businesses?

It estimates a firm's ability to convert assets into cash. Liquid assets can be swiftly and easily converted into cash or cash equivalents. 

Businesses utilize current assets to run operations, manufacture items, advertise, or create value. Assets can include things like equipment or even factories. 

The stock of goods, or the products a firm sells to generate sales, is usually considered a current asset because it would probably be sold in the short term. 

For an asset to be considered liquid, it must have a well-entrenched market with several potential buyers. Also, the asset must be able to change ownership easily and swiftly.

A good position regarding liquidity can help the firm smoothly carry out its operations, weather better through times of financial hardship, secure loans, and invest in research and growth.

Companies with low liquidity ratios risk encountering more financial difficulties concerning their operations and ability to pay short-term debt. As a result, It may have to start taking more loans to pay previous ones, sell business units and face imminent bankruptcy.

What is a liquidity crisis?

For an economy, a liquidity crisis means that the two vital sources of liquidity, cash from banks and commercial paper bought and sold on the interbank market, are greatly cut down.

In such a time of crisis, banks stop giving out loans. Firms in the country suffer because they rely on these loans to meet their short-term obligations. It can further decrease firms' liquidity as customers spend less, borrow, and save more.

Because the public is skeptical of the bank's ability to uphold its long-term obligations, there is a run on banks as people try to empty their deposits in bank accounts. Such a situation is called a bank run.

Heavy, undesirable financial shocks or basic cyclical economic changes can cause liquidity crises. The former is generally more damaging.

A liquidity crisis can also be an ailment for a single firm. When a business lacks the short-term assets to meet its short-term obligations, it faces a liquidity crisis. 

Debts include repaying loans, ongoing operational expenses, and wages.

Even if such companies have enough assets to meet these needs in the long run, an ability to pay them in the short term could potentially lead to bankruptcy.

Comparison with other accounting metrics

Within the domain of financial ratios lies accounting ratios. Accounting ratios are formulas used to evaluate a company's performance so that the company's liquidity, efficiency, and profitability can be evaluated.

These help the firm's management track business performance but also help external stakeholders such as financial analysts, creditors, tax authorities, consultants, etc. In addition, this determines the company's profitability and compares it with other potential investment opportunities.

When it comes to management accounting, the most commonly used financial ratios are solvency ratios, liquidity ratios, profitability ratios, and activity ratios. Among these, solvency ratios are most commonly confused with liquidity ratios.

Both these accounting ratios are used to evaluate the financial stability of a company. Solvency ratios and liquidity ratios are used by management to track financial performance, while investors can use them to gauge the profitability of investing in the company.

Whereas liquidity ratios measure how well a company can meet its short-term obligations, solvency ratios measure its ability to meet its long-term obligations.

Solvency ratios are used by potential credits to evaluate the solvency state of a company. Businesses with a higher solvency ratio are deemed more likely to repay their long-term debts, while businesses with smaller solvency ratios are less likely to receive loans.

Efficiency ratios help investors analyze a company's ability to turn short-term assets into revenue. In contrast, liquidity ratios measure the company's ability to meet short-term debt obligations.

Assets are listed on a firm's balance sheet and can have cash in the bank, marketable securities, current stock, goodwill, plant, machinery, etc. 

Efficiency ratios look at various aspects of the business, such as the time it takes to collect money from debtors. Therefore, this metric is very important, especially regarding comparable company analysis.

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Issues with Liquidity Ratio Analysis

Accounting metrics are used by businesses of all sizes and countries to diagnose the company's profitability, financial health, liquidity, future direction, and more.

These ratios reveal important information and allow management to make decisions that would be better for the firm's financial standing. For example, At face value, liquid ratio analysis measures a firm's liquidity or how well it can use current assets to cover current liabilities.

There are drawbacks to this, and whether you are an analyst, accountant, or investor, you must be wary of these restrictions.

1. Bad debt

Is a cost incurred when debtors cannot pay their debts and default on their loans? In other words, bad debt is accounts receivable that cannot be collected. 

Businesses that give credit to their customers must keep provision for bad debt, as there's always a possibility that the debtor's circumstances will change such that they won't be able to absolve their debts.

A company, for example, might have a large number of account receivables that are bad debt and will never be recovered, but this will pollute our calculation of the company's liquidity.

Liquidity analysis can produce misleading results. To mitigate this problem, a more detailed examination of the company's assets and liabilities must focus on evaluating the recoverability of certain current assets.

2. Problems with stock

A few of the ratios within the domain of liquidity ratios consider "the stock of goods" that a company holds as liquid assets, which can lead to misinterpretations.

A firm might have a build-up of inventory because of low sales, and a metric such as the current ratio would show a false projection of the company's liquidity.

An example of this problem is shown earlier with the case of The Spacing Guild, where the company had a good current ratio but an unhealthy quick ratio because it had a high amount of inventory.

3. Concern with timing

A cash flow that marginally falls outside of a ratio's parameters could seriously impact the target entity.

For example, a loan from another firm may be due in slightly over 365 days, so it would not be listed under current liabilities.

The opposite is also true. For example, the company might have accounts receivables that would not be covered within the year and might be requisitioned slightly after 12 months.

Additionally, these ratios are calculated based on a firm's performance in the past and might not be a good indicator of its financial position in the future.

Forged numbers in financial statements

Liquid ratio analysis is done using company financial reports' values. However, the firm's directors may distort this information to showcase a healthier result than its actual business performance. 

Accounting manipulation is when the managers of a company intentionally misinterpret financial figures to show a better financial standing for their company. This is considered illegal and unethical, yet it has been known to occur.

For this reason, this type of ratio analysis may inaccurately show the true liquidity position of a firm, as the forgery of numbers in the financial reports would not be shown in these simple calculations.

Before drawing any conclusions about the company, It is important to be wary of such distortions in the financial statements and to check for potential manipulations within the financial reports.

Financial statement fraud is when companies misrepresent or manipulate investors into believing their companies are making more money than they are.

Management may do this for various reasons, such as to gain more capital through selling shares and even for personal benefit.

Key Takeaways

  • Liquidity is the ability of securities and assets to be converted into cash without affecting their market value.
  •  Businesses need liquid and non-liquid assets since it helps you get through tough financial times and pay off debts quickly. 
  • Liquid assets can be quickly turned into cash without losing their market value. At the same time, non-liquid purchases are not easily liquidated as they must be sold and transferred into ownership to access their cash value.
  • There are five main categories of liquidity ratios, and these include current ratios, quick ratios, CCC, internal defensive ratios, and cash ratios.
  • Problems with these ratios can arise due to bad debt, forged numbers in financial statements, excessive inventory, or problems with timing.
  • Heavy, undesirable financial shocks or basic cyclical economic changes can cause liquidity crises. The former is generally more damaging.
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Researched and written by Omair Reza Laskar | LinkedIn

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