Liquidity Ratio Analysis

Liquidity ratio analysis is the use of multiple ratios to determine an organization's capacity to pay its payments on time. This study is critical for lenders and creditors who wish to get a sense of a borrower's or customer's financial status before extending credit. There are various ratios available for this research, all of which compare liquid assets to short-term obligations.

Understanding Liquidity Ratios

Liquidity is the capacity to convert resources into currency easily and quickly. When used in comparison, liquidity ratios are most useful. This examination could be internal or external.

Internal study of liquidity ratios, for example, requires the use of numerous accounting periods that are reported using the same accounting procedures. Analysts can track changes in the firm by comparing historical periods to current operations. In general, a greater liquidity ratio indicates that a corporation is more liquid and has better debt coverage.

External analysis, on the other hand, entails comparing the liquidity ratios of one company to another or an entire industry. When creating benchmark targets, this information can be used to compare the company's strategic stance to that of its competitors.

When examining across industries, liquidity ratio research may not be as helpful because different businesses demand different funding structures. When comparing enterprises of different sizes in different geographical locations, liquidity ratio analysis is less effective.

Types of Liquidity Ratios

The following are examples of popular liquidity ratios:

1. Current Ratio
2. Quick Ratio
3. Cash Ratio
4. Defensive Interval Ratio
5. Cash Conversion Cycle

Current ratio

Current Ratio = Current Assets / Current Liabilities

The current ratio is the easiest liquidity ratio to calculate and comprehend. On a balance sheet, anyone may quickly find the current assets and current liabilities line items. Divide current assets by current liabilities to get the current ratio.

Quick ratio

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

Compared to the current ratio, the fast ratio is a stricter liquidity test. Both have the same numerator and denominator because current liabilities serve as the denominator and current assets serve as the numerator.

However, the fast ratio only takes into account specific current assets. More liquid assets are considered, such as cash, accounts receivable, and marketable securities. Since they are less liquid, current assets like inventories and prepaid expenses are not included. The fast ratio is a better measure of a company's ability to fulfill its short-term obligations as a result.

Cash ratio

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

The cash ratio pushes the liquidity test even farther. This ratio only takes into account a company's most liquid assets, which are cash and marketable securities. They are the assets that a corporation has the most readily available to satisfy short-term obligations.

You can think of the current ratio, quick ratio, and cash ratio as easy, medium, and hard assessments of liquidity, respectively.

Special Considerations

If conditions develop that make it impossible for them to meet short-term obligations like loan repayment and employee payment, a liquidity crisis may develop even at healthy enterprises. The worldwide credit crunch of 2007–2009 is the best illustration of such a broad-reaching liquidity calamity in recent memory. This financial crisis was largely caused by commercial paper, which is short-term debt issued by large corporations to fund current assets and settle current liabilities.

It was extremely difficult for even the most solvent enterprises to raise short-term cash at that time due to a near total freeze in the $2 trillion U.S. commercial paper market, hastening the demise of massive corporations like Lehman Brothers and General Motors.

Key Takeaways

Liquidity ratios are a set of financial indicators used to assess a debtor's ability to pay down current debt commitments without requiring outside financing. The quick ratio, current ratio, and days sales outstanding are common liquidity ratios.

Liquidity ratios assess a company's capacity to meet short-term obligations and cash flows, whereas solvency ratios focus on a company's ability to pay off long-term debts.