LIQUIDITY INDICATORS: WHAT ARE THEY FOR, CALCULATION, ANALYSIS, EXAMPLES - DUDAS - 2025

The liquidity indicators are an important class of financial indices used to determine the adequacy of a debtor to repay debt obligations without increasing short - term foreign capital.

They measure the ability of a company to pay debt obligations and its margin of safety through the calculation of metrics, such as the circulating indicator, the rapid indicator and the operating cash flow indicator.

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Liquidity is not just a measure of how much cash a company has. It is also a measure of how easy it will be for the organization to raise enough cash or convert assets to cash.

Assets such as accounts receivable, securities transactions, and inventory are relatively easy for many companies to convert to cash in the short term. Therefore, all these assets enter into the liquidity calculation of a company.

Current liabilities are analyzed relative to liquid assets to assess short-term debt coverage in an emergency.

Working capital as an indicator

The amount of a company's working capital is also cited as an indicator of liquidity.

However, a company with a large amount of inventory that is difficult to sell may have a high amount of working capital and a favorable circulating indicator, but may be illiquid.

Therefore, the accounts receivable turnover ratio and the inventory turnover ratio can provide better information on a company's ability to convert current assets into cash on time to pay obligations when due.

What are liquidity indicators for?

Liquidity indicators show a company's cash levels and the ability to convert other assets into cash to pay for liabilities and other short-term obligations.

Circulating indicator

The current indicator measures a company's ability to pay short-term liabilities, which must be paid over the course of a year, with current assets, such as cash, accounts receivable, and inventories.

This means that a company has a limited amount of time to raise funds to pay these liabilities. Current assets such as cash, cash equivalents, and marketable securities can easily be converted to cash in the short term.

This means that companies with larger amounts of current assets will be able to pay their current liabilities more easily when they mature, without having to sell long-term, income-generating assets.

The higher the liquidity indicator, the better the company's liquidity position.

Quick indicator

It measures the ability of an organization to meet its short-term debts with the most liquid assets. Therefore, it excludes inventories from current assets. Also known as 'acid test indicator'.

Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered fast assets.

Short-term investments or marketable securities include marketable securities and available-for-sale securities that can easily be converted to cash within the next 90 days.

Marketable securities are traded on an open market with a known price and readily available buyers. Any stock on the New York Stock Exchange would be considered a commercial security, because it can be easily sold to any investor when the market is open.

The litmus test of finance shows how well a business can quickly convert its assets to cash to pay for current liabilities. It also shows the level of fast assets relative to current liabilities.

Pending sale days

It refers to the average number of days it takes for a company to collect payment after making a sale.

Higher days to sell mean that a company is taking too long to collect payment and is tying up its equity in accounts receivable.

How are they calculated?

Circulating indicator

It is calculated by dividing current assets by current liabilities. This relationship is indicated in numeric format, rather than in percentage format. Here is the calculation:

Current indicator = Current assets / Current liabilities.

Companies require the balance sheet to separate current and long-term assets and liabilities. This division allows investors and creditors to calculate important ratios such as the current indicator.

In financial statements, current accounts are always reported before long-term accounts.

Quick indicator

The quick gauge is calculated by adding the cash, cash equivalents, short-term investments, and current accounts receivable, and then dividing by current liabilities.

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

Sometimes the company's financial statements don't give a quick asset breakdown on the balance sheet. In this case, the quick measure can still be calculated even if some of the quick asset totals are unknown.

You simply subtract your inventory and prepaid expenses from your total current assets for the numerator. That is, another way to express this is:

Quick indicator = (Current assets - Inventory - prepaid expenses) / Current liabilities.

Pending sale days

Sales days pending are generally calculated on a quarterly or yearly basis, averaging the accounts receivable for the period and dividing by daily revenue: Days pending sale = Average Accounts Receivable / Revenue per day.

Analysis

Liquidity is the ability to convert assets to cash quickly and inexpensively. Liquidity indicators are most useful when used comparatively. This analysis can be internal or external.

Internal analisis

Internal analysis on liquidity indicators involves the use of multiple accounting periods that are reported using the same accounting methods.

Comparing previous time periods with current operations allows analysts to track changes in the business.

In general, the higher a liquidity indicator is, it will show that a company is more liquid and has better coverage of outstanding debts.

External analysis

External analysis involves comparing the liquidity indicators of one company with another, or with an entire industry. This information is useful to compare the strategic positioning of the company in relation to its competitors, when setting benchmarks.

Analysis of the liquidity indicator may not be as effective when analyzing different industries, since companies in different industries require dissimilar financing structures.

The liquidity indicator analysis is less effective in comparing companies of different sizes in different geographic locations.

Difference between solvency and liquidity

Unlike liquidity indicators, solvency indicators measure the ability of a company to meet its full financial obligations.

Solvency relates to the general ability of a company to pay debt obligations and continue business operations, while liquidity is more focused on current financial accounts.

A company must have more total assets than total liabilities to be solvent and more current assets than current liabilities to be liquid.

Although solvency is not directly related to liquidity, liquidity indicators show a preparatory perspective regarding the solvency of a company.

The solvency indicator is calculated by dividing a company's net income plus depreciation between its short-term and long-term liabilities. This indicates whether the net income of a company can cover its total liabilities.

In general, a company with a higher solvency ratio is considered a more favorable investment.

Examples

A couple of these liquidity indicators can be used to demonstrate their effectiveness in assessing the financial condition of a company.

Consider two companies, Company A and Company Z, with the following assets and liabilities on their balance sheets (figures in millions of dollars). Both companies operate in the same manufacturing sector.

In this example it will be assumed that current liabilities only consist of accounts payable and other liabilities, with no short-term debt.

For company A, if the formulas are taken to calculate the corresponding indicators, we have:

- Circulating indicator = $ 30 / $ 10 = 3.0.

- Quick indicator = ($ 30- $ 10) / $ 10 = 2.0.

Similarly, for company Z the corresponding formulas for the indicators are applied:

- Circulating indicator = $ 10 / $ 25 = 0.40.

- Quick indicator = ($ 10- $ 5) / $ 25 = 0.20.

Conclusions

A series of conclusions can be drawn about the financial condition of these two companies from these indicators.

Company A has a high degree of liquidity. Based on your current metric, you have $ 3 of short-term assets for every $ 1 of current liabilities.

Its quick indicator points to adequate liquidity, even after excluding inventories, with $ 2 in assets that can be quickly converted to cash for every dollar of current liabilities. To summarize, Company A has a comfortable liquidity position.

Company Z is in a different position. The company's current indicator of 0.4 shows an inadequate degree of liquidity with only 40 cents of current assets available to cover every $ 1 of current liabilities.

The quick indicator suggests an even more serious liquidity position, with only 20 cents of liquid assets for every $ 1 of current liabilities. In general, Company Z is in a dangerous liquidity situation.

References

1. Will Kenton and Adam Hayes (2019). Liquidity Ratio Definition. Investopedia. Taken from: investopedia.com.
2. Accounting Coach.com (2019). What is a liquidity ratio? Taken from: accountingcoach.com.
3. My Accounting Course (2019). Liquidity Ratios. Taken from: myaccountingcourse.com.
4. Cleartax (2018). Liquidity Ratio, Formula With Examples. Taken from: cleartax.in.
5. Steven Bragg (2018). Liquidity Ratios. Accounting Tools. Taken from: accountingtools.com.
6. Rosemary Peavler (2019). Liquidity and Liquidity Ratios. The Balance Small Business. Taken from: thebalancesmb.com.