Liquidity ratio: Meaning, calculation, and Benefits

Liquidity ratio is a major class of financial assessments used to determine a debtor's capacity to repay existing liabilities without raising external capital.

What is a Liquidity Ratio?

A Liquidity ratio is a financial ratio that determines the ability of a company to pay its short-term debt obligations. This metric helps to determine whether a company can use its existing or liquid assets to cover its current liabilities. The current ratio, quick ratio, and cash ratio are three commonly used. Given the ratio structure, the ratios above 1.0 are sought with upward assets and downward liabilities. A 1 ratio means a company can with its current assets precisely pay off its existing liabilities. A ratio below 1 (e.g., 0.75) means that a company is unable to meet its existing obligations. A ratio higher than one (for instance, 2.0) means that an enterprise can meet its existing bills. A 2.0 ratio allows a company to double the coverage of its current liabilities. A ratio of 3.0 means that they are three times more able to cover their current liabilities.

Understanding Liquidity Ratios

Liquidity allows for the quick and cheap conversion of assets into cash. When used in comparative forms, liquidity ratios are most useful. This can be an internal or external analysis. For instance, internal liquidity ratio analysis involves multiple accounts reporting periods using the same accounting methods. The analyzer can track changes in business by comparing previous periods and current activities. A higher liquidity ratio generally demonstrates that a company is more liquid and has greater debt coverage. The external analysis also requires the comparison of the liquidity ratios between one company and the other or the whole sector. This information is useful for comparing the strategic positioning of the company for its competitors when setting criteria. Analysis of liquidity ratio may not be as effective as different businesses require different funding structures when looking at the industry. Analysis of the liquidity ratio is less effective in comparing enterprises of various sizes at different locations.

Liquidity Ratio Analysis: Meaning?

Liquidity rating analysis uses several ratios to determine an organization's ability to pay its debts quickly. This analysis is important for lenders and lenders, who want to get an idea of ​​the borrower's or client's financial situation before giving them credit. There are a few statistics available for this analysis, all of which use the same concept of comparing liquid assets and short-term liabilities. These values ​​are: The amount of money. He compares the amount of money and investments in short-term loans. This measure does not cover any assets that may be immediately converted to cash, especially for inventory. Fast rate. It is similar to accounting but includes accounts that are available as assets. This measure clearly avoids the establishment, which can be difficult to convert into cash. Current rate. It compares all current assets to all current liabilities. This measure includes an establishment, which is not particularly liquid, and which could negatively represent the monetization of the business.

Significance

Liquidity ratio settlement is an important factor in the selection of strategies by the financial management team. High-yield stocks are said to be "waiting on the sidelines." Managers who work with those funds may think that the assets they usually invest in are overly balanced and hold a large amount of money while waiting for stock prices and bonds to fall. Joint currencies tend to have a higher share rate after financial markets move forward faster and financial managers sell stocks and winning bonds to lock in profits.

Upcoming Forecast

While a higher share rate may indicate that stocks and bonds have improved significantly faster, it may also indicate an increase in stock prices and bonds. If a large amount of consolidated funds holds a large sum of money, that money will need to be invested in something other than cash and cash equivalent in the near future. Cash and cash equivalents return very low yields, and managers who hold those assets for too long will have an undesirable return at the end of the year. Therefore, when the fund rate rises, the biggest pressure on the management team is to find the right amount and spend that money.

Types of Liquidity Ratios

1. Current Ratio

Current Ratio = Current Assets / Current Liabilities The current ratio is the most simplistic liquidity ratio to measure and interpret. Anyone can simply find the current assets and current liabilities line details on a company’s balance sheet. Divide prevailing assets by prevailing liabilities, and you will appear at the current ratio.

2. Quick Ratio

Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities The quick ratio is an extra stringent test of liquidity than the prevailing ratio. Both are related in the sense that current assets are the numerator, and current liabilities are the denominator. However, the quick ratio only holds certain prevailing assets. It holds more liquid assets such as cash, accounts receivables, and marketable bonds. It leaves out prevailing assets such as inventory and prepaid expenses because the two are small liquid. So, the quick ratio is more extra of a true test of a company’s capacity to cover its short-term obligations.

3. Cash Ratio

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities The cash ratio becomes the test of liquidity even more. This ratio only reflects a company’s most liquid assets – cash and marketable securities. They are the assets that are most easily available to a company to pay short-term obligations. In times of how strict the tests of liquidity are, you can see the current ratio, quick ratio, and cash ratio as smooth, medium, and hard.

Importance of Liquidity Ratios

• Gain the ability to cover temporary bonds

Water rates are important for investors and lenders to determine if a company can meet its short-term obligations, and to what extent. A rating of 1 is better than a rating of less than 1, but it's not good. Lenders and investors like to see high-interest rates, such as 2 or 3. If the rate is high, the company can pay off its short-term liabilities. A rating of less than 1 means that the company is facing improper operating costs and maybe facing a shortage of funds.

• Determine creditworthiness

Lenders analyze the amount of money when deciding whether to lend to a company or not. They want to make sure that the company they are lending to can repay them. Any suggestions for financial instability can prevent a company from getting a loan.

• Find investment suitability

For investors, they will analyze the company using stock ratings to ensure that the company is financially sound and worth its investment. Effective financial problems will set limits on the rest of the business. The company needs to be able to pay off its short-term debts by a certain road. Low emission rates raise a red flag, but "higher, better" is only true to some degree. Sometimes, investors will ask why liquidity ratios are so high. Yes, a company with an average withdrawal rate of 8.5 will be able to confidently repay its short-term debt, but investors may see such an excess rate. The unusually high rate means that the company owns a large number of liquid assets. In terms of available revenue, there is a balance between a company that is able to securely cover its debts and the unfair distribution of funds. Capital money should be allocated in the best way to increase the value of the shareholder firm.

Which is better: Solvency Ratios and Liquidity Ratios?

Contrary to liquidity ratios, solvency ratios measure the ability of a company to satisfy its financial and long-term total liabilities. Solvency concerns the overall capacity of an enterprise to pay liabilities and continue the business, while liquidity is more focused on short-term financial accounts and current accounts. To be solvent, a company must have more total assets than total liabilities; a company must have more current assets to be liquid than current liabilities. While solvency does not directly relate to liquidity, liquidity ratios are preliminary for a company's solvency. The solvency ratio is determined by dividing the net income and depreciation of a company into its short- and long-term liabilities. This shows whether the net income of a company can cover its total liabilities. A company with a higher solvency ratio is generally regarded as an investment more favorable.

What if a company is not liquid with ratios?

In this instance, even healthy companies may experience a liquidity crisis—where it becomes difficult to fulfil short-term obligations, such as reimbursement of their credits and payment of their workers or suppliers. The 2007–09 global credit crunch, which many companies found incapable of providing short-term finance for their immediate obligations, was one example of an extremely large liquidity crisis from recent history. In the absence of new financing, the company may have to liquidate assets in a fire sale or apply for protection against bankruptcy.

Liquidity ratio of mutual funds

A ratio of cash and cash of a mutual fund equal to the current assets invested in it. In other words, if a mutual fund has much cash it has not invested in securities, the ratio is higher while the ratio is lower if all or almost all its liquidity is invested. A high ratio is considered a bizarre indicator because this means that investments with strong returns are difficult for the Mutual Fund and hence larger cash stocks are being kept. Every month, mutual funds publish cash ratios.

Calculator Use Liquidity Ratio

This calculator will find solutions that fall into the four-step process of shutting down a business or organization - current rate, fast rate, cash rate, and operating cost. The calculator can calculate one or two sets of data points, and will only give the results of those measurements based on the input provided by the user. If you are analyzing one company for a single reporting period, fill in the available data points in column A and press calculate - results will show below. If you are analyzing two companies or one company for two reporting periods, use both columns A (low) and B (seconds). For each data point and value ratio in both columns, the change expressed as a percentage increase or decrease will also be calculated. The values ​​that fall in the selection box determine the collection values ​​themselves. Percentage changes are always calculated at four key values.

Why is the calculation of liquidity ratios so important?

There are many reasons for calculating and evaluating the liquidity ratios. The entity itself might want to evaluate its liquidity ratios to ensure that a low rate is not expected by creditors, bankers, shareholders and other stakeholders due to a poor liquidity ratio. These ratios will also be examined in the executive performance evaluation by the board of directors. In their analysis, these ratios are mainly evaluated by banks, creditors, and investors. Before you provide loans, loans or invest in the new fund, you want to know what is healthy for your business. These groups of stakeholders usually have big beliefs not too deeply concerned with the entity when the ratios are too bad. This is also the purpose why an entity requires to make sure the ratio looks great from time to time.

Conclusion

There are various other Liquidity Ratios that you may require to attach to your ratios analysis base on the kind of industries and other parts that your company is operating in. To get your ratio speak-able, the Liquidity ratio may require to link with expectation, industry analysis, and or from the competitors. Besides just seeing into cash flow, other non-financial factors need to be also be evaluated.

Also Read, Foreign Account Tax Compliance (FATCA) & CRS – Regulations, Declarations & Requirements A Comprehensive Guide to Income Tax Slabs in India New Changes In Custom Duties In Budget 2021 To Promote Domestic Manufacturing