Companies calculate varying types of liquidity ratios by dividing total current assets by total current liabilities. Here, assets include liquid money as well as those holdings that can be quickly converted into cash. Typically, businesses with higher liquidity ratios (i.e. one or higher) are seen as safer and more likely to follow through on their obligations than those with lower ratios.
Importance of Tracking Liquidity
There are multiple reasons for companies to track liquidity ratios. Because lenders and financial analysts use liquidity ratios to assess a company’s creditworthiness, businesses that lack sufficient cash flow may struggle to secure loans. Additionally, liquidity ratios are of special interest to mortgage originators, who may deny you a loan if your liquidity is too low.
Of course, companies also have internal reasons for tracking their liquidity ratios. As your business’ financial manager, you are responsible for ensuring that the company can follow through on its commitments, such as accounts payable, salaries and tax bills in the coming quarters. By calculating liquidity on a regular basis, businesses can identify potential problems in the early stages, when it’s still possible to make adjustments.
Types of Liquidity Ratios
The following are the most commonly tracked liquidity ratios among business owners:
The current ratio measures liquidity by comparing assets to liabilities. Also known as working capital ratio, a business’ current ratio is equal to total current assets divided by total current liabilities, or all the debts due within a year of statement data. Generally, current liabilities include accounts payable, wages payable and upcoming tax bills, as well as any principle payments on loans.
Many creditors feel that a current ratio of 2:1 indicates that a firm is financially healthy, while a smaller ratio can be suggestive of an unsound investment.
While most lenders believe a higher current ratio signifies a healthier company, experts warn that this tracking ratio is flawed. The current ratio measure relies on the assumption that a company can liquidate all its assets in order to satisfy liabilities. However, the fact is that many holdings are not easy to immediately convert to cash. To track fiscal health accurately, companies should utilize multiple liquidity ratios instead of relying on just one measure.
More conservative than other liquidity metrics, the quick ratio is a measure used to assess a company’s capacity to fulfill its promises.
To calculate quick ratio, businesses subtract inventories from current assets, which include cash, equivalents, marketable securities and accounts receivable. This number is then divided by total current liabilities. Quick ratios are also known as acid-test ratios.
Unlike the current ratio, the quick ratio excludes inventories from non-cash assets. As a result, many creditors see current ratio as a more accurate measure of a company’s overall worth. In general, a high quick ratio means a better liquidity position for the company.
Many companies track quick ratios on a monthly basis to help identify negative trends and make adjustments that will allow them to satisfy debt requirements moving forward. For best results, businesses should compare their current ratios to those of previous years as well as those of their competitors.
Operating Cash Flow Ratio
To measure operating cash flow, simply add up the total cash taken in from operations and then divide this value by current liabilities.
Also known as the OCF ratio, operating cash flow assesses whether current cash flow is sufficient to cover a business’ debts. Because companies pay a number of their bills in cash, lenders feel that operating cash flow is one of the best measures of short-term liquidity.
Calculating liquidity ratios enables businesses to make more educated decisions about their spending. By identifying liquidity issues early, you can assure lenders that you will follow through on your obligations while boosting the chances that your company will survive.
Want more accounting ratios? See our article on the seven accounting formulas every business should know.