How much do you know about your business’ financial health? When it comes to a company’s financial security, there’s no room for guesswork (or at least there shouldn’t be). Fortunately, there’s a powerful tool that can help you better understand your organization’s finances: the liquidity ratio.
There are multiple types of liquidity ratios, each of which can provide valuable information about your company’s financial well-being. Here’s a detailed look at liquidity ratios and how to use them.
What Is a Liquidity Ratio?
Liquidity ratios measure a company’s assets against its financial obligations. They tell you whether your liquid assets are enough to cover what you owe in the short term. Owners and stakeholders can use these calculations to guide business decisions.
To understand how liquidity ratios can guide business decisions, you first need to understand how each ratio is formatted. To calculate a liquidity ratio, divide a company’s liquid assets (and, in some cases, those that are easily liquidated) by its liabilities.
If the result is at least 1, the company has at least enough assets to cover its current expenses. If it’s less than 1, the company can’t pay its current liabilities with its current assets. Essentially, the greater the liquidity ratio, the easier it is for a company to pay its current obligations.
It’s important to note that while a higher number is generally better, it doesn’t mean that a company with a lower ratio is necessarily doing any better or worse.
A company’s liquidity ratio can serve as a measure of its financial health, so it can be used in a variety of different ways:
- By business owners and executives to determine overall financial stability (and to determine whether the business should liquidate more of its assets)
- By investors to determine whether investing in a company is worth the risk
- By lenders to determine whether a company should be approved for credit
To further learn how to use liquidity ratios, it’s important to first understand their various types.
Types of Liquidity Ratios
There are three main types of liquidity ratios. Each type tells you something different about your company. Here’s a rundown of the three main types of liquidity ratios and when to use them.
1. Current Ratio
The current ratio is the most straightforward, at least in terms of calculation. It shows a company’s ability to pay off its current liabilities (debts payable within a year) with its current assets (including inventory, accounts receivable, and cash).
2. Quick Ratio
You may have heard the quick ratio referred to as the “acid-test” ratio. It’s somewhat similar to the current ratio but only factors in a company’s most liquid assets when assessing its ability to cover short-term obligations. This means that when you total current assets, you exclude the value of any inventory.
To calculate a quick ratio, you add up a company’s marketable securities, accounts receivable, and cash (plus cash equivalents). You then divide the total by current liabilities.
3. Cash Ratio
A company’s cash ratio measures its ability to cover short-term debts using only cash and cash equivalents. That means it excludes inventory, accounts receivable, and other assets from the equation.
How to Use Liquidity Ratios
While all of the aforementioned ratios are useful, each one tells you something different. Before you start calculating your company’s liquidity ratios, make sure you know which one to use (and how).
Step 1: Choose the Appropriate Type of Ratio
Begin by choosing which ratio will best answer your questions. Here’s a brief guide to making an informed selection:
- Choose a current ratio if you need long-term insights and a general idea of a company’s liquidity
- Choose a quick ratio if you want shorter-term insights and a more stringent picture of liquidity
- Choose a cash ratio if you want the most conservative view of a company’s liquidity (or if you’re applying for a line of credit)
Once you’ve determined the right metric for your needs, you can gather the relevant financial data and start calculating. If you want as strong of an understanding of your business’ financial position, you might as well calculate all 3 liquidity ratios.
Step 2: Calculate the Ratio
Here’s what you’ll need to calculate each ratio:
- Current Ratio: The value of all current assets (meaning assets you can turn into cash within a year), including inventory, accounts receivable, and cash
- Quick Ratio: The value of your company’s “quick” (most liquid) assets, including accounts receivable, marketable securities, cash, and cash equivalents
- Cash Ratio: The value of your company’s cash reserves and easily marketable (“near-cash”) securities
You’ll also need to total your current liabilities for each of these ratios. Current liabilities are financial obligations you have during each operating cycle (or, in some cases, every year).
Many businesses have a range of current liabilities. Here are some of the most common:
- Employee compensation and benefits
- Notes payable
- Accounts payable
- Income taxes
- Short-term loans
- Income taxes
- The current portion of any long-term debt you have
Take your time gathering the information you need. Many companies base business decisions at least partly on liquidity ratios, so you want to verify that your data points are as complete and accurate as possible.
Step 3: Examples of Calculating Liquidity Ratios
The best way to understand liquidity ratios and how they work is to apply them in practice. Let’s look at a couple of real-world examples.
Example 1
Snow Line Metals has historically enjoyed steady revenue, but a new mega-corporation has begun eating into its profits. Snow Line’s executives are worried that the company is headed for disaster, and they want to ensure that the company has enough money to pay off its short-term debts if business slows dramatically.
Which ratio is best in this situation? The executives are worried about a very near-term financial disaster, so they need to see if Snow Line can pay its debts quickly if needed. In this case, a quick ratio is ideal.
The executives would gather the following values:
- Current Liabilities: $50,000
- Cash: $100,000
- Easily Marketable Securities: $10,000
- Accounts Receivable: $100,000
Quick ratio = (marketable securities + accounts receivable + cash and cash equivalents)/(current liabilities)
When you plug in the values above, you get the following:
Quick ratio = ($10,000 + $100,000 + $100,000)/($50,000) = 4.2
Generally, a quick ratio of more than one is considered “good,” so Snow Line looks very secure for the short term.
Example 2
Joe, a small business owner, wants to hire another employee. However, his company’s finances have been getting tighter, and he wants to make sure he can comfortably afford to pay another worker.
Because Joe needs to see beyond the short term, his best bet is to calculate a current ratio. He gathers the following data points:
- Inventory: $100,000
- Accounts Receivable: $50,000
- Cash: $50,000
- Marketable Securities: $10,000
- Current Liabilities: $200,000
Current ratio = ($100,000 + $50,000 + $50,000 + $10,000)/$200,000 = 1.05
Most experts consider a current ratio of two or more to be solid. Joe’s company’s ratio is 1.05, indicating that there might be problems covering expenses over the coming year. This suggests that Joe probably shouldn’t hire another employee — and he should probably look at cutting back expenses elsewhere, too.
Tips and Special Considerations
Here are a few other things to keep in mind when it comes to liquidity ratios.
Importance of Liquidity
Liquidity isn’t the only thing that matters when evaluating a company’s financial health. However, a certain degree of liquidity is essential for stability.
Debt and Its Role
All else being equal, greater debt means lower liquidity. If you have a considerable amount of debt, make sure you have enough liquidity to comfortably cover it (and any other financial obligations) if need be.
Other Metrics to Watch: Cash Flow and Working Capital
These two metrics don’t directly measure liquidity, but they can add important context to liquidity measurements.
“Cash flow” is the difference between a company’s opening and closing balances for a given revenue cycle. Greater liquidity often (but not always) leads to greater cash flow.
“Working capital” is the money your company has tied up in accounts receivable and inventory (minus accounts payable, accrued expenses, etc.). For lenders and investors, a company with high working capital (even if it also has high liquidity) usually appears riskier because so much of its cash flow is held in accounts like these.
Why Liquidity Ratios Matter
When you’re running a business, there’s little room for error. Saying your company can comfortably cover its liabilities is one thing, but when you can definitively quantify a business’s ability to pay, you will have the precise numbers you need to make confident decisions.
Liquidity ratios are essential for determining these precise numbers. Whether you need to get a sense of the company’s long-term outlook, understand its short-term financial health, or see how likely you are to be approved for credit, there’s a liquidity ratio that can help.
When you understand which liquidity ratios to use and when, you can spot potential risks, remedy them, and keep your business running smoothly.
