Understanding Liquidity Ratios: Types and Their Importance (2024)

What Are Liquidity Ratios?

Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio.

Understanding Liquidity Ratios

Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios are most useful when they are used in comparative form. This analysis may be internalor external.

For example, internal analysis regarding liquidity ratios involves using multiple accounting periods that are reported using the same accounting methods. Comparing previous periods to current operations allows analysts to track changes in the business. In general, a higher liquidity ratio showsa company is more liquid and has better coverage of outstanding debts.

Alternatively, external analysis involves comparing the liquidity ratios of one company to another or an entire industry. This information is useful to compare the company's strategic positioning to its competitors when establishing benchmark goals. Liquidity ratio analysis may not be as effective when looking across industriesas various businesses require different financing structures. Liquidity ratio analysis is less effective for comparing businesses of different sizes in different geographical locations.

Types of Liquidity Ratios

The Current Ratio

Thecurrent ratiomeasures a company's ability to pay off its current liabilities (payable within one year) with its total current assets such as cash, accounts receivable, and inventories. The higher the ratio, the better the company's liquidity position:

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$CurrentRatio=CurrentLiabilitiesCurrentAssets​

The Quick Ratio

The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assetsand therefore excludes inventories from its current assets. It is also known as the acid-test ratio:

$\begin{aligned} &\text{Quick ratio} = \frac{C + MS + AR}{CL} \\ &\textbf{where:}\\ &C=\text{cash \& cash equivalents}\\ &MS=\text{marketable securities}\\ &AR=\text{accounts receivable}\\ &CL=\text{current liabilities}\\ \end{aligned}$​Quickratio=CLC+MS+AR​where:C=cash&cashequivalentsMS=marketablesecuritiesAR=accountsreceivableCL=currentliabilities​

Another way to express this is:

$\text{Quick ratio} = \frac{(\text{Current assets - inventory - prepaid expenses})}{\text{Current liabilities}}$Quickratio=Currentliabilities(Currentassets-inventory-prepaidexpenses)​

Days Sales Outstanding (DSO)

Days sales outstanding (DSO)refers to the average number of days it takes a company to collect payment after it makes a sale. A high DSO means that a company is taking unduly long to collect payment and is tying up capital in receivables. DSOs are generally calculated on a quarterly or annual basis:

$\text{DSO} = \frac{\text{Average accounts receivable}}{\text{Revenue per day}}$DSO=RevenueperdayAverageaccountsreceivable​

Special Considerations

Aliquidity crisiscan arise even at healthy companies if circ*mstances arise that make it difficult for them to meet short-term obligations such as repaying their loans and paying their employees. The best example of such a far-reaching liquidity catastrophe in recent memory is the global credit crunch of 2007-09. Commercial paper—short-term debt that is issued by large companies to finance current assets and pay off current liabilities—played a central role in this financial crisis.

A near-total freeze in the $2 trillion U.S. commercial paper market made it exceedingly difficult for even the most solvent companies to raise short-term funds at that time and hastened the demise of giant corporations such as Lehman Brothers and General Motors (GM).

But unless the financial system is in a credit crunch, a company-specific liquidity crisis can be resolved relatively easily with a liquidity injection (as long as the company is solvent). This is because the company can pledge some assets if it is required to raise cash to tide over the liquidity squeeze. This route may not be available for a company that is technically insolvent because a liquidity crisis would exacerbate its financial situation and force it into bankruptcy.

Solvency Ratios vs. Liquidity Ratios

In contrast to liquidity ratios,solvencyratios measure a company's ability to meet its total financial obligations and long-term debts. Solvency relates to a company's overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current or short-term financial accounts.

A company must have more total assets than total liabilities to be solvent; a company must have more current assets than current liabilities to beliquid. Although solvency does not relate directly to liquidity, liquidity ratios present a preliminary expectation regarding a company's solvency.

The solvency ratio is calculated by dividing a company'snet incomeanddepreciationby its short-term andlong-term liabilities. This indicates whether a company's net income can cover itstotal liabilities. Generally, a company with a higher solvency ratio is considered to be a more favorable investment.

Examples Using Liquidity Ratios

Let's use a couple of these liquidity ratios to demonstrate their effectiveness in assessing a company's financial condition.

Consider two hypothetical companies—Liquids Inc. and Solvents Co.—with the following assets and liabilities on their balance sheets (figures in millions of dollars).We assume that both companies operate in the same manufacturing sector (i.e., industrial glues and solvents).