What Is Liquidity Ratio? How Does Liquidity Ratio Works

Liquidity ratios are ratios that measure a company’s ability to meet its short-term debt obligations when due.The liquidity ratio is the result of dividing cash and other liquid assets by short-term loans and current liabilities.In general, the higher the liquidity ratio, the higher the safety margin a company has to meet its current obligations. If the liquidity ratio is more than 1, it shows that the company is in good financial health.

What Is Liquidity Ratio? How Does Liquidity Ratio Works

 

What Can We See Through Liquidity Ratios?

Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios will be useful when used in the form of comparisons.

For example, through internal analysis, we will see that liquidity ratios involve the use of the same accounting periods. Comparing previous time periods with current operations allows analysts to track changes in business.

Meanwhile, external analysis involves comparing liquidity ratios between one company and another, or across industries.

This information is useful to see the company’s position in relation to competitors when setting benchmark targets .

General Liquidity Ratio

What Is Liquidity Ratio? How Does Liquidity Ratio Works

  • Current ratio

Current ratio can measure a company’s ability to pay its current liabilities (paid in one year) with current assets such as cash, receivables, and inventory.

The higher the ratio, the better the company’s liquidity position.

The formula is as follows:

Current ratio = Current assets / Current liabilities

  • Quick ratio

The quick ratio serves to measure a company’s ability to meet short-term liabilities with the most liquid assets and hence, exclude inventory from current assets. The fast ratio is also known as the “acid test ratio”.

The formula is as follows:

Quick ratio = (Cash + cash equivalents + valuable securities + receivables) / Current liabilities

Or

Quick ratio = (Current assets – inventory – upfront costs) / Current liabilities

  • Daily outstanding sales (DSO)

DSO refers to the average number of days required by a company to collect payment after making a sale.

A higher DSO indicates that the company takes too long to collect payments and tie up capital in accounts receivable. This DSO is generally calculated quarterly or annually.

The formula is as follows:

DSO = Average receivables: Earnings per day

  • Absolute liquidity ratio

This ratio measures the total liquidity available to companies. This ratio will consider the securities as well as the cash available to the company. This ratio examines short-term liquidity in terms of cash, securities and current investments.

The formula is as follows:

Absolute liquidity ratio = (Cash + securities) / Current liabilities

  • Basic defense ratio

This ratio measures the company’s inability to bear cash costs without additional financial assistance from other sources.

The formula is as follows:

Basic defense ratio = (cash + receivables + securities) / (operating costs + interest + tax) / 365

Liquidity crisis

A liquidity crisis can arise even in healthy companies, if something comes up that makes it difficult for them to meet short-term obligations such as paying employees or paying loans.

An example that we can take to explain the liquidity crisis that has a wide impact is the global credit crisis in 2007-2009.

Short-term securities issued by large companies to finance current assets and pay off current liabilities play a central role in this crisis.

However, unless the financial system is in a credit crunch, the company’s specific liquidity crisis can be resolved relatively easily through liquidity injection as long as the company is solven.

This is because companies can pledge assets if they are required to raise cash to deal with liquidity pressures.

This route may not be available for companies that are technically bankrupt because the liquidity crisis will worsen their financial condition.

Difference between Solvency Ratio and Liquidity Ratio

In contrast to liquidity ratios, solvency ratios measure a company’s ability to meet its total financial obligations. Solvency is closely related to a company’s ability to pay debt obligations and continue business operations. While liquidity is more focused on the current financial account.

Companies are also required to have more total assets than total liabilities to become solvents and have more current assets from current liabilities to liquid.

Although solvency is not directly related to liquidity, the liquidity ratio presents initial expectations regarding the solvency of the company.

The solvency ratio is calculated by dividing the net income of the company and the derivation with its short-term and long-term obligations.

This will show whether the company’s net profit is able to cover its total obligations. In general, companies with higher solvency ratios are considered more profitable investments.

Example

Component amount
Cash and cash equivalents 2188
Short-term Investment 65
Accounts Receivable 1072
Stock 8338
Other Current Assets 254
Current Total Assets 11917
Debt Account 4560
Extraordinary Cost 809
Tax must be paid 307
Deferred income 998
Income Tax Payable 227
Other Extraordinary Loads 1134
Current Total Obligations 8035

Information:

  1. Operating costs for this year are 2188
  2. The net interest paid during this year is 25
  3. The tax paid is 1913
  4. Current Ratio = Current Assets / Current Liabilities
  5. Quick ratio = (Current assets – Inventory) / Current liabilities

= (11971 – 8338) / 8035

= 0.45

  1. Basic Defense Intervals = (Cash + Receivables + Securities) / (Operating Costs + Interest + Tax) / 365

= (2188 + 1072 + 65) / (11215 + 25 + 1913) / 365

= 92.27

  1. Absolute Liquidity Ratio = (Cash + Securities) / Current liabilities

= (2188 +65) / 8035

= 0.28

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