Liquidity Ratio - Explained
What is a Liquidity Ratio?
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Table of ContentsWhat is a Liquidity Ratio?How is a Liquidity Ratio Used?KEY TAKEAWAYS Common Liquidity RatiosThe Quick Ratio or acid-test ratioThe Current RatioDays Sales Outstanding (DSO):Cash Ratio: Liquidity CrisisThe Difference Between Solvency Ratios and Liquidity RatiosAcademic Research on Liquidity Ratios
What is a Liquidity Ratio?
A liquidity ratio is a financial ratio that examines the capability of a company to settle its liabilities, both current and long-term debts using its assets. Liquidity ratios help in determining the financial solvency of a company or an individual or otherwise, as the case may be. There are many methods of examining the ability of a debtor to pay off its liabilities, examples of liquidity ratios include quick ratio or acid-test ratio, cash ratio, current ratio, capital ratio and others. Liquidity ratios also examine the sufficiency of the current assets of a debtor to clear its liabilities without accessing any external funding.
Back to: ACCOUNTING, TAX, & REPORTING
How is a Liquidity Ratio Used?
Liquidity ratio indicates the ability of a company o debtor to pay off all of its liabilities using its liquid assets without resorting to any form of external financing. The presence of liquid assets in a company or how easily a company can convert its assets to cash is referred to as liquidity. Typically, cash is the basic or standard form of liquidity in any organization, when used, liquidity ratios help to highlight the sufficiency of the current or liquid assets of a company in paying its debts. Liquidity ratios are used for the purpose of analyzing the current assets and liabilities of form with the aim of comparing them and determining how well the current assets can clear off the liabilities. Liquidity ratios can be used for two forms of analysis, these are internal analysis and external analysis. Internal analysis is carried out to examine the financial changes in a business, it entails comparing accounting statements of different accounting periods to understand the differences in the liquidity of a company for various periods. When the liquidity of the two companies is compared, external analysis has taken place. The comparison is often done using two companies in different industries to evaluate the effectiveness, performance, and liquidity of the companies.
Here are the major points you should know about liquidity ratios;
- Liquidity ratios are important metrics that evaluate the ability of a company, individual or debtor to clear its debts and liabilities using its liquid and current assets.
- Liquidity ratios measure whether the liquid assets of a firm are sufficient to pay its liabilities without the firm accessing external funding.
Common Liquidity Ratios
Below is a highlight of common liquidity ratios and their formulas
The Quick Ratio or acid-test ratio
There are two formulas for quick ratio, they are; Quickratio= (Cash+cashequivalents+marketablesecurities+accountsreceivable)/Currentliabilities ) Quickratio= (Currentassets-inventory-prepaidexpenses)/ Currentliabilities This liquidity ratio measures how a firm settles its financial obligations with liquid assets which excludes its inventories.
The Current Ratio
CurrentRatio=CurrentLiabilities - CurrentAssets The current ratio is the simplest form of liquidity ratios, it examines the ability of a debtor to pay its short-term liabilities by deducting the current liabilities from the current assets. Other liquidity ratios are:
Days Sales Outstanding (DSO):
DSO= Average accounts receivable/ Revenue per day
Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities
A liquidity crisis is an unpalatable situation that occurs when a debtor is unable to meet short-term financial obligations or when the liquid assets of the debtor are insufficient to pay off its liabilities. When a firm is in a liquidity crisis, making investments becomes difficult, paying back loans, clearing off expenses and settling all financial obligations because very difficult. Whether big or small, any company can land in a liquidity crisis, when this happens, to revive the company is made easy through liquidity pumping. However, when a financial system is in a credit crunch, this is an unpalatable situation that causes a financial crisis. This means companies in the liquidity crisis at this period might not receive any aid, even if they are solvent.
The Difference Between Solvency Ratios and Liquidity Ratios
While liquidity ratios focus on the ability of a debtor to pay off all short-term debts using its current assets, solvency ratios examine how a company settles all its financial obligations, both long-term and short term. Liquidity refers to the presence of cash in a company and how liquid assets are easily converted into cash to pay all short-term debts. Solvency, on the other hand, has to to with the ability to meet all long-term financial obligations and still continue in business. In some cases, when liquidity ratios are used in examining the status of a company, they give a sneak peep into the solvency or otherwise of the company.
Academic Research on Liquidity Ratios