LIQUIDITY RATIOS: WHAT IS LIQUIDITY AND EXAMPLES - DUDAS - 2024

The liquidity ratios are indicators used to analyze the ability of a company to pay both its current liabilities when due, as their long - term liabilities when they become current.

In other words, these ratios show a company's cash levels and the ability to convert other assets into cash to pay for liabilities and other short-term obligations. They are commonly used by potential creditors and lenders to decide whether to grant credit or debt to companies.

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The liquidity of a company is the ability to meet its short-term financial obligations. Therefore, liquidity ratios attempt to measure the ability of a company to pay its debt obligations in a short space of time.

These ratios are based on different parts of the company's current assets and current liabilities, taken from the balance sheet.

Determine payment capacity

Liquidity ratios are a key part of essential analysis, as they help determine a company's ability to pay its debts. If a company does not pay what it owes, it could face bankruptcy activity or restructuring, which could be detrimental to shareholder value.

These measures compare various combinations of relatively liquid assets to the amount of current liabilities on an organization's balance sheet. The higher the ratio, the better a company's ability to pay its obligations in a timely manner.

What is liquidity?

Someone mentioning liquidity in an investment is generally referring to an entity's ability to convert its assets into cash. In other words, a business analyst might want to know how quickly a company can get its funds to cover its outstanding bills.

Liquidity is a sign of your financial health, as it is important for companies to have enough cash to cover their payment obligations on an ongoing basis, without having to turn to outside sources to raise capital.

The liquidity of a business company is generally of particular interest to its short-term creditors, as the amount of liquidity that exists speaks volumes about the company's ability to pay those creditors.

In general, the higher the value of the liquidity ratio, the greater the margin of safety a company has in its ability to pay its bills.

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 company to raise enough cash or convert assets to cash.

Liquid assets

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

This is done by comparing the company's most liquid assets with its short-term liabilities.

In general, the liquidity ratio will be better the higher the level of coverage of liquid assets with respect to short-term liabilities.

Low liquidity

A company with low liquidity should alert investors, as it can be a sign that the company will have difficulty meeting its short-term financial obligations and consequently carrying out its daily operations.

During difficult times for the economy or business, a company with insufficient liquidity could be forced to make difficult decisions to meet its obligations. These could include the liquidation of productive assets, the sale of inventory, or even a business unit.

List of liquidity reasons (with examples)

Current ratio

The current ratio measures the ability of a company to layer its short-term liabilities with its current assets. The formula is: current assets divided by short-term liabilities.

As an example, a company with $ 10 million in current assets and $ 5 million in current liabilities would have a current ratio of 2.

A current ratio greater than 1 is indicative that the company is well positioned to cover its short-term liabilities.

A current ratio of less than 1 could be a sign of trouble if the business is in financial difficulties.

Precautions when using this ratio

When looking at the current ratio, investors should be aware of the types of current assets the company has and how quickly these can be converted to cash to meet current liabilities.

For example, how quickly can the company collect all of its outstanding accounts receivable? An analyst would like to know how long it takes for the company to receive payment after a sale is made.

For companies with inventory, how quickly can this inventory be liquidated if the need arises, and what percentage of the inventory value is the company likely to receive?

The current ratio assumes that the company could liquidate most of its current assets and convert them to cash to cover these liabilities.

However, this is unlikely if the company is to remain an operating company, as a certain level of working capital will still be required.

Quick reason

The quick ratio, also called the acid test ratio, is a liquidity ratio that further refines the current ratio, by measuring the level of the most liquid current assets available to cover current liabilities.

The quick ratio is more conservative than the current ratio, because it excludes inventory and other current assets, which are generally more difficult to convert to cash.

In general, inventory is considered less liquid than other current assets.

The formula for calculating the quick ratio is: (cash equivalents + marketable securities + accounts receivable) divided by current liabilities.

By focusing on current assets, which are the easiest to convert to cash, this ratio is a better gauge of the coverage these assets provide for the company's current liabilities, should the company experience financial difficulties.

Reason analysis

A general rule of thumb is that a quick ratio greater than 1 means that a company is capable enough to meet its short-term obligations.

A company with a high and / or rising rapid ratio is likely experiencing revenue growth, rapidly collecting its accounts receivable, and probably rapidly converting its inventories.

A fast low and / or declining ratio could indicate that the company's sales are declining, that the company is having a hard time collecting its accounts receivable, or perhaps that it is paying its invoices too quickly.

The elimination of inventory makes the quick ratio a somewhat better indicator than the current ratio of an organization's ability to meet its short-term obligations.

Cash ratio

The cash ratio is another measure of a company's liquidity and its ability to meet its short-term obligations. The formula for the cash ratio is: (cash + marketable securities) divided by current liabilities.

The elimination of accounts receivable, used in both current and fast ratios, and the elimination of inventories, which is part of the numerator of the current ratio, leaves a ratio that shows the level of cash and investments close to the cash of the company, in relation to its current liabilities.

Worst case

The cash ratio is almost like an indicator of the value of an organization in the worst case when the company is about to go out of business.

This ratio tells creditors and analysts the value of current assets that could be quickly converted to cash, and the percentage of the company's current liabilities that could be covered by these cash assets.

The cash ratio is rarely used in financial reporting or by analysts in fundamental analysis of an entity. It is unrealistic for a company to maintain excessive levels of cash and assets close to cash to cover current liabilities.

Cash Conversion Cycle (CCE)

It measures the number of days that a company's cash is tied to the production and sales process of its operations, and the benefit that is obtained by the payment terms of its creditors.

The shorter this cycle, the more liquid the company's working capital position will be.

The calculation is as follows: (days of inventory pending + days of sale pending) - days to pay pending.

Outstanding inventory days are the measure of the time it takes to convert inventory to cash. This indicator is calculated by dividing the company's average inventory by the daily cost of sales.

Pending days of sale are calculated by dividing the average amount of accounts receivable by the daily net sales amount. Provides an estimate of how long it takes a business to collect sales that go into the company's accounts receivable.

Outstanding days payable are calculated by dividing the company's average amount of accounts payable by the daily cost of sales. Provides an estimate of how long it takes the company to pay its suppliers.

Importance

The CCE is vital for two reasons. First, it is an indicator of the company's efficiency in managing its working capital assets. Second, it provides a clear view of an organization's ability to pay its current liabilities.

A smaller CCE means more liquidity, which translates into less need to borrow. In contrast, a larger CCE increases the company's cash needs.

References

1. Roger Wohlner (2017). Liquidity Measurement Ratios. Investopedia. Taken from: investopedia.com.
2. Roger Wohlner (2017). Liquidity Measurement Ratios: Current Ratio. Investopedia. Taken from: investopedia.com.
3. My Accounting Course (2019). Liquidity Ratios. Taken from: myaccountingcourse.com.
4. Roger Wohlner (2017). Liquidity Measurement Ratios: Quick Ratio. Investopedia. Taken from: investopedia.com.
5. Roger Wohlner (2017). Liquidity Measurement Ratios: Cash Ratio. Investopedia. Taken from: investopedia.com.
6. Steven Bragg (2018). Liquidity Ratios. Accounting Tools. Taken from: accountingtools.com.
7. Roger Wohlner (2017). Liquidity Measurement Ratios: Cash Conversion Cycle. Investopedia. Taken from: investopedia.com.