2019-07-25 13:21:01Finance and AccountingEnglishLiquidity ratio analysis helps in measuring the short-term solvency of a business, that is, a company’s ability to meet its short-term...https://quickbooks.intuit.com/in/resources/in_qrc/uploads/2019/07/An-image-showcasing-increasing-stack-of-coins-to-display-the-concept-of-Liquidity-Ratio-Analysis.jpghttps://quickbooks.intuit.com/in/resources/finance-and-accounting/understanding-liquidity-ratio-analysis/Understanding Liquidity Ratio Analysis

Understanding Liquidity Ratio Analysis

11 min read

What is Liquidity Ratio Analysis?

Liquidity ratio analysis helps in measuring the short-term solvency of a business. This means it helps in measuring a company’s ability to meet its short-term obligations. Thus, liquidity suggests how quickly assets of a company get converted into cash. Further, it ensures that a business has uninterrupted flow of cash to meet its current liabilities. Also, liquidity suggests that a company has sufficient funds to meet its day-to-day business operations.

Hence, this suggests that the very conversion of current assets into cash should be so quick so as to ensure timely payment to outsiders. That is to say, the majority of current assets should not get tied up in inventories and credit sales (that is accounts receivables). Otherwise, the company will run of out of cash to meet its current debt obligations.

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Given this scenario, simply calculating liquidity ratios for a given period does not give a fair view of the company’s short-term solvency. It is also extremely important to analyze the quality of current assets to know the true liquidity position of a company.

Liquidity Ratio Analysis Example

A study was undertaken to compare the financial performance of two electric giants ABB and Rockwell. The principal technique used for conducting such a financial statement analysis included ratio analysis.

Thus, current ratio was used to analyze the short-term solvency of these electric multinationals for the given period. This ratio is apart from the other set of ratios that were calculated. These other ratios included solvency ratios, asset turnover ratio and return on capital employed.

Analysis

As per the study, it was concluded that ABB had an average current ratio of 1.49 for the period 2013 – 2016. On the other hand, Rockwell had an average current ratio of 2.69 for the same period.

Typically, a current ratio less than 2 indicates that a company does not have sufficient assets to meet its short-term obligations. In other words, a company is growing its sales faster than it can finance them. This situation can lead the company into insolvency. It is because the company is attempting to adjust more customers willing to purchase its goods relative to its capacity to fund them.

Thus, ABB’s low current ratio for the period suggests liquidity crisis for the company in the short-term. This makes it necessary for ABB to invest in current assets in order to meet its short-term financial obligations.

Likewise, a current ratio more than 2 indicates poor financial planning on the part of Rockwell. This hints towards poor quality of current assets on Rockwell’s balance sheet that might include slow paying debtors or unsold inventory.

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Therefore, the above analysis suggests that liquidity analysis is an important tool to measure the short-term solvency of a company. So, let’s understand what are the types of liquidity ratios and their relevance.

Types of Liquidity Ratios

The common liquidity ratios include:

  • Current Ratio
  • Quick Ratio
  • Cash Ratio
  • Defensive Interval Ratio
  • Cash Conversion Cycle

1. Current Ratio

Current ratio is one of the liquidity ratios. This ratio evaluates a company’s ability to meet its short-term obligations. These obligations are the ones that are typically due within a year.

Thus, this ratio is also known as working capital ratio. It measures a company’s assets relative to its current liabilities. Thus, such a ratio determines the short-term solvency of the company. Further, it also indicates the ways in which a company can convert its current assets into cash to meet its short-term debt and payables.

Although, current ratio determines the short-term solvency of a company at a particular time. However, it does not give a complete picture of its liquidity. For instance, a company having a very high current ratio may be the result of increased bills receivable. This is on account of slow paying debtors. Or such a high ratio is the result of the company’s inability to sell its inventory.

Therefore, it is important for business owners or managers to check the quality of the assets rather than simply calculating the ratios.

Formula used for calculating current ratio is as follows:

Current Ratio = (Current Assets/Current Liabilities)

Financial managers refer the balance sheet of a company for current assets that include: (i) inventory, (ii) cash, (iii) accounts receivable and (iv) other assets that can be liquidated within a year. Current liabilities on the other hand include (i) accounts payable, (ii) outstanding expenses like wages, taxes etc. and (iii) short-term debt.

Also, a current ratio that is acceptable for one industry may not be justifiable for the other. This means that the ratio varies by industry. Therefore, such a ratio should be in line with or a little higher than the industry average.

What Does Current Ratio Indicate?

A current ratio lower than the industry average suggests higher risk of default on the part of the company. This is because the company is growing its sales way beyond its capacity to finance the same. This may lead to lesser cash or slow conversion of bills receivables to pay for current liabilities.

Likewise companies having too high a current ratio relative to the industry standard suggests that they are using their assets inefficiently. This means poor financial planning on the part of the company as too much funds are blocked in the current assets that lead to idle capital.

Illustration

For instance, following are the items on the balance sheet of Kapoor and Co.

A table showcasing current assets of Kapoor Ltd in order to explain the concept of liquidity ratio analysis

Thus the current ratio for Kapoor and Co. can be calculated as:

Current Ratio = (Current Assets/Current Liabilities)
= 1,34,000/1,04,000
= 1.29:1

Where,

Current Assets = Inventories + Trade Receivables + Advance Tax + Cash and Cash Equivalents
= Rs 50,000 + Rs 50,000 + Rs 4,000 + Rs 30,000
= Rs 1,34,000

Current Liabilities = Trade Payables + Short-Term Borrowings
= Rs 1,00,000 + Rs 4,000
= Rs 1,04,000

2. Quick Ratio

Quick ratio is a more cautious approach towards understanding the short-term solvency of a company. This is because it includes only the quick assets which are the more liquid assets of the company. Just like current ratio, a higher quick ratio also indicates that a company’s assets are highly liquid to meet its short term debt obligations. But quick ratio proves to a better liquidity measure as compared to the current ratio.

This is because firstly, quick ratio does not consider certain current assets such as prepaid expenses, advance taxes etc.It is so because such expenses have been paid in advance and cannot be converted into cash. Secondly, current assets like inventory are also not considered while calculating quick ratio. This is because these assets cannot be quickly converted into cash.

Thus, we can conclude that assets that can be converted in a very short period of time are categorized as quick assets. This period is restricted to 90 days or less. That is to say only the accounts receivables that can be collected within 90 days are considered as quick assets. Likewise, inventories are not included in quick assets. This is because the company may have to offer hefty discounts in order to sell its inventory within 90 days or so.

Hence, the formula for calculating quick ratio is as follows:

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

or

Quick Ratio = (Current Assets – Inventory – Prepaid Expenses)/(Current Liabilities)

Illustration

For instance, following are the items on the balance sheet of Kapoor and Co.

A table showcasing current assets of Kapoor Ltd in order to explain the concept of liquidity ratio analysis through Quick Ratio

Quick Ratio = Quick Assets/Current Liabilities
= 80,000/1,04,000
= 0.77:1
Where

Quick Assets = Current Assets – (Inventories + Advance Tax)
= Rs 1,34,000 – (Rs 50,000 + Rs 4,000)
= Rs 80,000

Current Liabilities = Rs 1,04,000

3. Cash Ratio

Cash ratio is one of the liquidity ratios that measures company’s total cash and cash equivalents relative to its current liabilities. This ratio indicates the ability of the company to meet its short-term debt obligations using its most liquid assets. These assets include:

  • cash on hand,
  • demand deposits and
  • cash equivalents like t-bills, money market accounts and savings accounts.

It is a very reliable approach towards understanding the short-term solvency of the company in comparison to the other liquidity ratios. This is because it does not take into consideration assets such as accounts receivable, inventory and prepaid expenses. It is so because accounts receivable might take time to convert. On the other hand, prepaid expenses usually cannot be converted into cash. Similarly, a company may take time to sell its inventory that may make it illiquid.

Thus, the formula for calculating cash ratio is as follows:

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

What Does Cash Ratio Indicate?

A cash ratio equivalent to one suggests that the company has exactly the same amount of cash and cash equivalents as the current liabilities. This cash can be utilized to pay its short-term debt obligations.

On the other hand, cash ratio less than one suggests that the company has insufficient cash to meet its current liabilities.This may not be an issue with the companies having a long payment cycle and a short collection period. Furthermore, it also includes companies that manage their inventory efficiently.

Lastly, a cash ratio more than one indicates that the company has more than sufficient cash to pay off it current debts. This means that the company has some amount of cash even after meeting its short-term debt obligations. However, too high cash ratio is not a good indicator as it reveals improper financial planning on the part of the company. The excess cash lying idle would rather be invested in high return projects.

Illustration

For instance, following are the items on the balance sheet of Kapoor and Co.

A table showcasing current assets of Kapoor Ltd in order to explain the concept of liquidity ratio analysis through Cash Ratio

Cash Ratio = Cash + Cash Equivalents/Current Liabilities
= Rs 30,000/Rs 1,04,000
= 0.29:1

4. Defensive Interval Ratio

This ratio ascertains the time period for which the company can continue to pay off its expenses from its existing pool of liquid assets. This is without receiving any additional cash inflow.

Say for instance, a company has a defensive interval ratio of 60. This means that the company can continue to pay of its operating expenses for a period of 60 days before all of its quick assets get exhausted. The assumption here is that no additional cash flows are received by the company for these 60 days.

Just like other liquidity ratios, a higher defensive interval ratio suggests greater liquidity.There are situations where a company might have a very low defensive interval ratio as compared to its competitors or its own ratio in the previous years. In such a case, the financial manager would want to know if expected cash flows are sufficient enough to fill the gap.

The formula for calculating defensive interval ratio includes:

Defensive interval ratio (in number of days) = Current Assets/Daily Operational Expenses

Where

Current Assets = Cash + Marketable Securities + Net Receivables

Daily Operational Expenses = (Annual Operating Expenses – Non-Cash Charges)/365

5. Cash Conversion Cycle

Cash conversion cycle is a measure that determines the time period that transpires from the point when working capital is invested till the time the company collects cash. Generally, when a company buys inventory on credit, it leads to increase in bills payable. Eventually, when the company sells the final goods on credit, it leads to increase in accounts receivable.

Further, it collects cash against accounts receivable and pays cash against accounts payable. Thus, the time period between the outflow of cash and the inflow of cash forms the cash conversion cycle. This is also known as net operating cycle.

Lesser the time period between cash inflow and outflow, higher the liquidity. Such short cash conversion cycle means that the company needs to finance its accounts receivable and inventory for a short period of time.

Likewise, greater the time period between cash outflow and inflow, lower the liquidity. A longer cash conversion cycle means that the company must finance its accounts receivable and inventory for a long period of time.

The formula for calculating cash conversion cycle is as follows:

Cash Conversion Cycle = Days of Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding

Where,

Days Inventory Outstanding = (Average Inventory/COGS) * 365

Average Inventory = ½(Beginning Inventory + Closing Inventory)

Days Sales Outstanding = (Average Accounts Receivable/Revenue Per Day)

Average Accounts Receivable = ½(Beginning Accounts Receivable + Ending Accounts Receivable)

Days Payable Outstanding = (Average Accounts Payable/COGS Per Day)

Average Accounts Payable = ½(Beginning Accounts Payable + Ending Accounts Payable)

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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