Liquidity ratios – what they show and how you use them
The financial situation of a company is affected by many things, so it is advisable to monitor the maintenance of liquidity. Several liquidity ratios help to do this.
The liquidity situation
You may have read about liquidity before, so now the overview is in a nutshell.
Liquidity is the ability of a business to meet its obligations.
However it matters, that you can only do this in general or at any time. Just as it matters at what cost you can do that. You have to defer something else to be able to pay or be able to do it easily.
Basic concepts for monitoring liquidity and calculating liquidity ratios
Obligation not exceeding 1 year. This may be:
- Short-term loans, loans (with a term not exceeding 1 year)
- Repayment of long-term loans and credits due within 1 year
- Advances received from customers
- Debts to suppliers
- Other current liabilities (even tax liability)
The current asset serves the company within 1 year. These can be:
- Receivables (eg from customers, but may also be against anyone else.)
- Funds (cashier and bank account)
- Securities purchased for trading (short – term)
Stock / Inventory
Stocks are the tangible assets available to the enterprise for use within 1 year.
Receivable (trade receivable)
A claim is a payment claim legally arising from a contract that has already been settled by the contractor and accepted by the other party.
Funds (Cash and cash equivalents)
Permanently not deposited currency. These can be in cash, bill money and check. They can be registered not only in HUF, but also in different currencies.
Each liquidity ratio shows how much you can pay from short-term assets.
Depending on how strictly you interpret liquidity, that is, how quickly it is necessary to look at your solvency, you choose the liquidity ratio that is appropriate for your purpose.
Current ratio = Current assets / Current liabilities
If its value is less than 1, there is a risk of insolvency. It is acceptable to have a value above 1, but it is desirable to have a value around 1.2-1.3.
Nor is it appropriate for this indicator if its value is too high, after all, although the company is solvent, it does not make optimal use of the resources available to it.
Here the counter contains those current assets, that the faster can be monetized. For this reason, stocks are not taken into account because the duration of the ability of stocks to be monetised is already “slow” for this liquidity ratio.
You only write cash, liquid securities, and trade receivables into the counter.
Quick ratio = (Current assets – Inventories) / Current liabilities
You may ask why, if a trade receivable arises from inventory sold, why one goes out and why the other stays inside.
A trade receivable is a stock that has already been sold, so when you determine the quick liquidity rate, you can already see when you will have money from it. And for stocks, you must first find a buyer for it (unless your stock becomes unsaleable for any reason by then).
Because you are constantly monitoring your liquidity ratios, you will have a trade receivable from inventories during normal sales, which will already appear in the quick liquidity ratio.
Cash liquidity (Cash ratio)
Here we consider only the most liquid assets. Since it can take several days (or even weeks) for a trade receivable to see money from it, it has been removed from the counter here. We only monitor cash and liquid securities.
Cash liquidity = Cash / Current liabilities
The high value specifically indicates that the business has too large reserves. This can also have the effect of a sudden inflow of large sums of revenue in the short term (this obviously has its place), but in the long run it indicates that the company is not exploiting its potential. Since inflation affects everyone, it can be said that it produces losses in the long run.
At low value, most of a company’s resources are tied up in inventories and receivables. Apart from the very low values, this is not a problem, but it is definitely necessary to monitor. A loss event affecting inventories or the loss of a customer base and the decrease in solvency then have an increased impact on the operation of the company.
The question is how long the company will be able to operate and pay all its obligations if it ceases to generate revenue.
Duration indicator = (Current assets – Inventories) / Average daily operating expenses
As with the quick liquidity ratio, the counter includes cash, liquid securities, and trade receivables. The latter means the revenue already generated, while the sale of inventories and the revenue from it presuppose normal operation. Here, we assumed that there was no normal operation and thus no revenue from further sales.
Working capital = Current assets – current liabilities
Working capital shows how much free capital (current asset) a company has after settling liabilities. In case of a positive value, the company can also plan an increase in working capital, in case of a negative value, it must also use a part of its long-term purchased assets (ie fixed assets) to settle its short-term liabilities. This makes growth impossible and could be an obstacle to normal operation.
In the case of working capital, not only quantity but also ratio is important. Thus, this is usually interpreted in conjunction with the liquidity ratio.
Importance of the liquidity ratio
You may encounter a liquidity problem primarily in the case of a larger project. This can even be the realization of a larger investment, when it is not yet producing but already costs, but the company itself can also be considered a big project, so a start-up company is almost guaranteed to face liquidity problems.
Because liquidity ratios monitor exactly the items that change the fastest in a business’s life, you can’t do that by calculating once a year, an acceptable healthy result comes out, and then you sit back satisfied. In order to maintain the liquidity of your company and not be hampered by momentary insolvency, the development of indicators must be constantly monitored.
- How often do you monitor your own liquidity situation and its development?
- Which indicator do you usually use for this?
- What value do you consider healthy for your company for the liquidity ratio you choose?
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