Liquidity Ratios Explained

 

Liquidity ratios measure the ability of a company to use its short-term assets to meet its short-term liabilities (1,2).

Short-term assets, also called current assets, include cash, cash equivalents, accounts receivable, and inventory.

Short-term liabilities, also called current liabilities, are the payments due within the upcoming 12 months. Short-term liabilities include accounts payable to suppliers, interest on loans, and the portion of the loan balance due.

For the purposes of this article, we will lump the different types of short-term liabilities together under “current liabilities”. This is done to focus on the impact of the subcategories of current assets.

The most commonly used liquidity ratios are the Current Ratio, Quick Ratio, and Cash Ratio.

The Current Ratio is calculated by dividing current assets by current liabilities.

Current Ratio = (Cash + Cash Equivalents + Accounts Receivable + Inventory) / Current Liabilities

The Current Ratio greater than 1 indicates a company has sufficient current assets to cover current liabilities. If the Current Ratio is less than 1, the prudent investor or corporate strategist should look for an explanation as to how the company will meet current liabilities (1,2).

The Quick Ratio (also called the Acid-Test Ratio) is a more stringent measure. The Quick Ratio excludes inventory from current assets because inventory may take time to convert to cash.

Quick Ratio = (Cash + Cash Equivalents + Accounts Receivable) / Current Liabilities

If a company has any inventory, the Quick Ratio will be smaller than the Current Ratio. The Quick Ratio can be interpreted as the margin of safety in meeting current liabilities if inventory sales were to stall. Industries and companies differ in their “acceptable” Quick Ratios. Inventory management decisions can cause large differences between the Current Ratio and the Quick Ratio (1,2).

The Cash Ratio is the most conservative liquidity metric. The Cash Ratio includes only cash and cash equivalents. Cash and cash equivalents are the most liquid of assets. Accounts receivable may not be realized if customers have poor credit.

Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

If the company has accounts receivable, the Cash Ratio will be smaller than the Quick Ratio. It is important to remember the Current Liabilities may not all be due at the same time in the year. A Cash Ratio less than 1 may be acceptable if the company receives sufficient revenue, or holds sufficient cash balance, as each portion of the current liability comes due (1).

Conclusion: Low liquidity ratios indicate potential cash flow issues. Companies with low liquidity ratios may struggle to pay bills in a timely manner. Extremely high liquidity ratios may indicate inefficient use of capital. Companies with large amounts of cash, inventory, and receivables may be amassing current assets because they are unable to find opportunities for profitable growth (1,2).

References:

1. Libby R, Libby P, Hodge F. Financial Accounting (10th ed.). McGraw Hill, 2020.

2. Dyckman T, Hanlon M, Magee R, Pfeiffer G. Financial Accounting (5th ed.). Cambridge Business Publishers, 2017.

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