Even if a business has high profitability, it can face short-term financial problems if its funds are locked up in inventories and receivables not realizable for months.
A business has to pay its suppliers, meet current expenses like staff salaries and marketing incidentals, and other immediate obligations continuingly. Any failure to comply these can damage its reputation and creditworthiness, and in extreme cases, even lead to bankruptcy. Liquidity ratios are the business ratios that can reveal the likelihood and causes of any such problems.
What Do Liquidity Ratios Measure?
Liquidity ratios work with cash and near-cash assets (together called “current” assets) of a business on one side, and the immediate payment obligations (current liabilities) on the other side. The near-cash assets mainly include receivables from customers and inventories of finished goods and raw materials. The payment obligations include dues to suppliers, operating and financial expenses that must be paid shortly and maturing installments under long-term debt.
Liquidity ratios measure a business’ ability to meet the payment obligations by comparing the cash and near-cash with the payment obligations. If the coverage of the latter by the former is insufficient, it indicates that the business might face difficulties in meeting its immediate financial obligations. This can, in turn, affect the company’s business operations and profitability.
The near-cash assets are not all equal in their nearness to cash. Inventories are farthest from cash (apart from advance payments and such minor items) as they typically become receivables when sold which have to wait a further period before becoming cash. Receivables can also be very far from cash if customers are given several months to pay their dues.
It is thus the speed of converting the different near-cash assets into cash that is important. The cash conversion cycle measures this speed and is used along with liquidity ratios to assess a business’ short-term financial prospects.
We will now look at how the liquidity ratios are computed.
Liquidity Ratio Computations
- Current Ratio = Current Assets / Current Liabilities: Current ratio works with all the items that go into a business’ working capital, and gives a quick look at its short-term financial position. Current assets include Cash, Cash equivalents, Marketable securities, Receivables, and Inventories. Current liabilities include Payables, Notes payable, Accrued expenses and taxes, and Accrued installments of term debt).
- Quick Ratio = Current Assets minus (Inventories + Prepaid expenses + Deferred income taxes + Other illiquid items) / Current Liabilities: Quick ratio excludes the illiquid items from current assets and gives a better view of the business’ ability to meet its maturing liabilities.
- Cash Ratio = (Cash + Cash equivalents + Marketable Securities) / Current Liabilities: Cash ratio excludes even receivables that can take a long time to be converted into cash. This ratio is typically less than one because some cash can be expected to be generated from receivables and other sources. Holding too much cash is a poor investment of funds because cash does not produce any returns.
We will look at the other key measure of liquidity, cash conversion cycle, in a separate article.
A business can be profitable and yet be unable to meet its immediate payment obligations if it has weak liquidity. Liquidity is measured quickly by dividing current assets by current liabilities giving the current ratio. Current ratio can be misleading if current assets consist of a high proportion of illiquid items. The quick ratio and cash ratio give better measures of liquidity.