Companies use some parameters to assess the quality of their current operating activities. And some of those parameters are the liquidity ratios. They help companies to know their ability to cover short-term liabilities on time. This is because of emergency situations that could pop-up at any moment. So, as companies in the market, the knowledge of their liquidity ratios is paramount.
As you read along, you’ll learn more about liquidity ratios, their examples, and so on.
What are Liquidity Ratios?
Liquidity ratios are the ratios companies use to measure the ability of a company to meet their short-term debt obligations. With these ratios, companies can measure their ability to pay off short-term liabilities when they fall due. Besides that, liquidity ratios help companies to determine a debtor’s ability to pay off current debt obligations without raising external capital.
Liquid ratios help to measure the level of cash or assets that a company or individual could quickly convert into cash. And these assets help them meet their financial obligations.
How do liquidity ratios work?
Having seen the meaning of liquidity ratios, you would need to understand how it really works.
Now, liquidity is the ability of companies to convert assets into cash quickly and cheaply. And when they use them in comparative form, liquidity ratios become most useful. Therefore, this analysis (comparison of the liquidity ratios) may be internal or external.
Internal Analysis involves the use of multiple accounting periods they reported using the same accounting methods. When analysts compare previous periods to current operations, it allows them to track changes in the business. Then again, a higher liquidity shows a company is more liquid (easy to sell or convert into cash with no loss in its value). Consequently implying that the company has better coverage of outstanding debts.
Alternatively, External Analysis involves comparison of the liquidity ratios of one company to another or an entire industry. This information is useful for companies to compare their strategic positioning in relation to their competitors when they are establishing benchmark goals. However, liquidity ratio analysis may not be very much effective when looking across industries. This is because various businesses require different financing structures. Therefore, this analysis is less effective for comparing businesses of different sizes that are in different geographical locations.
What are types of liquidity ratios?
Having known the meaning of liquidity ratios, let’s look at their types. Liquidity ratios have three (3) common types, namely; current ratio, quick ratio and operating cash flow ratio
The following are types of liquidity ratios:
1. Current ratio
Current ratio helps to determine an organisation or individual’s ability to pay their short- and long-term debts. It helps to compare their total assets, both liquid and fixed, to their total debt.
2. Quick ratios
The quick ratio assesses an organisation’s most liquid assets (excluding inventories from the calculation). Besides that, it shows an organisation’s or individual’s ability to pay their short-term debts.
3. Operating cash flow ratio
Operating cash flow ratio helps to measure the ability of organisations or individuals to cover their current liabilities. These current liabilities could be due within one year. So they can cover their current liabilities using the cash they generated by their current operations.
What could happen if ratios show a company is not liquid?
‘Liquid’ is the state of being in a position where you have sufficient cash on hand to carry out all necessary financial obligations. In other words, liquidity in companies refers to the ease with which they can convert their asset, or security, into ready cash without affecting its market price. So, cash is the most liquid of assets. Whereas tangible items are less liquid.
However, a liquidity crisis can arise even at healthy companies. Especially if circumstances arise that make it difficult to repay their loans and pay their employees or suppliers. Therefore, if they cannot find new financing. The company would need to liquidate assets in a fire sale or seek bankruptcy protection.
In the end, the higher the liquidity ratios, the lower the credit risk (a company’s risk of default). This ratio is therefore crucial for lenders, especially when they’re evaluating potential loan clients. Companies meet their debts and even invest more when they are financially buoyant. Therefore, with the knowledge of liquidity ratios, companies will make the right financial decisions.