Liquidity ratio: what is it and how is it calculated?by Admin | August 26, 2021
Liquidity indicates a company's capacity to meet its short-term obligations, i.e. those not exceeding one year.
This will depend on the ease with which the company's assets can be converted into cash (liquid), money being the most liquid asset.
The liquidity ratio will measure this capacity, calculating the difficulty the company might have in meeting its most immediate obligations by converting its tangible assets into liquid.
By knowing it, it will be possible to anticipate decisions to better control cash inflows and outflows, forecast whether the company will be able to meet outstanding payments and measure the risk of insolvency.
It is one of the main indicators that allow, through its calculation, to know and improve the financial health of a company, together with the Working Capital Fund.
The elements of the balance sheet involved in the calculation of the ratio are:
Current assets, consisting of assets or rights with easy or short-term liquidity.
Current liabilities, made up of short-term obligations, which mature in a period of less than one year.
How to calculate the liquidity ratio
To calculate the liquidity ratio, as we have mentioned, we will have to have two elements of the company's balance sheet, current assets and current liabilities.
The operation to be performed will be the division between both concepts, so the formula will be as follows:
Liquidity Ratio = Current Assets / Current Liabilities.
Current assets include Inventories, Current Assets (short-term receivables) and Cash (bank accounts and cash). Current liabilities include short-term debts and obligations.
As we can see, the elements involved in the calculation of the liquidity ratio are the same as in the calculation of the Working Capital Ratio and the only thing that varies is the operation to be performed.
Interpreting the liquidity ratio
The resulting ratio will be the money that we will have for each monetary unit of debt that the company has. For example, if the result is 2, we will have $2 for each $1 of debt.
This number will be analyzed depending on whether it is higher or lower than a specific figure. This figure is not fixed, since it varies according to the activity, the sector and, sometimes, according to the article or study we consult.
There are companies that operate with very short collection periods or that have no stock or inventory, while others have longer collection periods and store large quantities of materials and stock, which directly affect the final result of the ratio calculation.
This is why it is important to know the ideal of the sector by comparing it with other companies that carry out the same activity in order to avoid making erroneous forecasts and wrong decisions.
Within the same company, the "ideal" figure with which to compare the liquidity ratio will also vary according to the time at which the calculation is made, since a company's liquidity needs vary according to the stage it is at.
Once the "ideal" figure has been obtained, which will normally be 1, 1.5 or 2, we can interpret the result of our ratio and see what the company's financial health is like. In this article we will consider this figure to be around 1.5.
Result > 1.5
Current assets are higher than current liabilities and the company will initially be able to meet its short-term obligations.
Even so, it must be borne in mind that not all the assets belonging to current assets are equally easily converted into cash, so we must always know what proportion of each asset item the company has.
If the company has a lot of cash, payments of short-term debts can be easily executed, while if it has a lot of inventories and little cash, we must be aware that there is a prior step to be taken before having this liquid to cover the company's obligations.
In addition, if the result of the ratio is much higher than 1.5, it could be the case that we are not getting the maximum benefit or profitability from our assets and that it is necessary to make some investment to support the development of our company.
In the case of having more cash than is really necessary, it could be interesting to take into account some resources such as Dynamic Discounting, which allows the company to obtain profitability from this idle cash.
Result < 1.5
In this case the company may be suffering liquidity problems and it is necessary to take into account other financing resources to maintain the activity.
Although it can be managed in an adequate way thanks to the different types of financing sources, it is better to know this information in time and make decisions about it, as it is not the ideal situation for a company.
The liquidity ratio will not only allow the company to know its financial health, but also to know how much financing it may need to be able to draw on.
This ratio may have a significant impact on the perception of the company's status by investors, affecting possible shares or participations, so it is important to keep it in mind and add it to strategic planning.