What are Liquidity Ratios?

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Definition:

Liquidity ratios are financial metrics that provide insight into a company’s ability to repay debt obligations without raising additional capital.

🤔 Understanding liquidity ratios

Liquidity ratios compare a company’s liquid assets to its short-term liabilities (payments due within the next year). This provides a snapshot of the company’s ability to meet near-term debt obligations, without selling equity or assets. A company with high liquidity ratios should have no problem paying its bills, while a low liquidity ratio signals that the company may have challenges. While liquidity ratios measure the ability of a company to raise the cash it needs when it needs it, solvency ratios measure the structural risk of not meeting its long-term financial needs. There are several different ways that liquidity can be measured, resulting in several liquidity ratios, including the cash ratio, current ratio, quick ratio, and operating cash flow ratio.

Example

Consider a fictional new winery. The new owner buys the land, wine barrels, and equipment. He plants the vines and builds the trellises. It might take more than a year before the first harvest. Then, he puts the wine in oak barrels to age for a year or more. This business has no revenue for the first few years of operation. It has assets (land, equipment, and inventory), but it’s difficult to convert those assets into cash. Therefore, the business probably has almost no liquidity and very poor liquidity ratios.

Takeaway

Liquidity ratios are like results from the NFL combine…

Every year, scouts put college football players through a series of tests. They measure how fast they run, how high they jump, and how far they can throw a football. Those measurements (ratios) give prospective coaches (investors) a good indication of how quick, agile, and strong the player (company) is at the time. But, it doesn’t measure how well they understand the game (industry), or how well they play it. Similarly, liquidity ratios measure specific aspects of how able a company is to meet its near-term debt obligations; but they don’t paint a complete picture of a company's long-term chances of success.

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What are liquidity ratios?

Liquidity ratios indicate the relationship between a company’s liquid assets and its short-term debt obligations. Liquidity refers to the speed at which an asset can be converted to cash. The general idea is that paying bills requires having access to cash. Therefore, cash is the most liquid asset of all. Other short-term investments can be converted to cash relatively quickly, meaning they are somewhat liquid. In contrast, a building might take a long time to sell, making it an illiquid asset.

While there are a few different measures of liquidity, all liquidity ratios use current liabilities in the denominator. Current liabilities are all of the invoices and debt service payments that the company must pay within the year. Therefore, liquidity ratios measure how difficult it will be to pay those bills.A liquidity ratio of 1:1 means that the company has enough money to pay all of those bills. Lower ratios imply that the business will need to raise more cash within the next few months. A need to raise more capital might signal that the company is likely to take on more debt, divest of some assets, or sell more equity. Any of those actions can potentially reduce the value of owning shares in the company.

What are the types of liquidity ratios?

There are four common liquidity ratios that analysts use to determine a company’s liquidity (ability to pay short-term obligations). These liquidity ratios differ based on the definition of liquidity they use.

Cash ratio

The cash ratio uses the strictest definition of liquidity. It’s the percentage of current liabilities that the company can cover with cash on hand and cash equivalents (things that can be converted to cash very quickly). Stocks, bonds, and government debt instruments fall into the category of cash equivalents.

Cash ratio = (cash + cash equivalents) / current liabilities

Quick ratio

Also known as the acid-test ratio, the quick ratio pulls accounts receivable into the equation. Accounts receivable are invoices that the company has sent out but haven’t been paid yet. They represent money that is due and should be received within the next few weeks or months. Together, these are called quick assets, which include all current assets other than inventory and prepaid expenses.

Quick ratio = (cash + cash equivalents + accounts receivable) / current liabilities

Current ratio

The current ratio takes inventory into account. Most businesses raise cash by selling merchandise. Therefore, inventory represents money that should be converted to cash over the next several weeks or months. However, an analyst might consider the fact that companies have very different abilities to convert inventory into cash. As such, an inventory turnover ratio analysis might play a role in evaluating a company's liquidity.

Current ratio = (cash + cash equivalents + accounts receivable + inventory) / current liabilities

The current ratio is sometimes called the working capital ratio. That’s because cash, cash equivalents, accounts receivable, and inventory combine to make current assets. The difference between current assets and current liabilities is working capital.

Operating cash flow ratio

Rather than using a company’s balance sheet to determine its ability to cover costs, analysts sometimes look at the cash flow statement. Cash flows are the revenues and expenses generated from conducting operations. Dividing operating cash flows by current liabilities yields how much of those obligations could be paid with the operational cash flows.

Operating cash flow ratio = operating cash flow / current liabilities

What are the liquidity ratios used for?

Analysts use liquidity ratios to gauge the financial health of a company. Higher liquidity ratios imply that there is little risk of default on debts. They also provide a glimpse into what actions the company might need to take over the next several months if they don't have enough cash. If a company doesn’t have enough working capital, it might be forced to sell assets, take on debt, or issue more shares of equity. Any of those actions could be adverse to an investor. Taking on debt or selling assets both imply a reduction in shareholder equity (assets minus liabilities). Likewise, issuing additional shares results in stock dilution, reducing the value of current interests.

What is a good liquidity ratio?

In general, higher liquidity ratios are better than lower ones. But, too high of a value might be a bad sign. A liquidity ratio of 1:1 means that the company has just enough of the measured liquid assets to cover all of its current liabilities. If that’s a measure of only cash, it has a different implication than if it includes inventory and other short-term assets. In general, there is a target range of acceptable liquidity ratios.

For the current ratio (current assets divided by current liabilities), that range is generally between 1.5 and 3.0 — A good target is 2:1. If the current ratio is higher than 3:1, it implies that assets are sitting idle rather than earning a return. Consequently, profitability ratios, like the return on equity, will be lower. Likewise, a current ratio below 1.5 might give an analyst pause, and a ratio below 1:1 could be a sign of trouble. Lower current ratios imply that the company must sell its inventory and collect its receivables to cover its expenses.

A quick ratio (current assets minus inventory divided by current liabilities) is always lower or equal to the current ratio. In general, a 1:1 rate is a good target for a quick ratio. Again, a value that is too high suggests that the company might not be using enough of its capital for growth or dividends. A number too low might indicate trouble ahead.

If you’re looking at the cash ratio, the value should probably be less than 1:1. Cash is the most liquid asset, but it is also the least productive. Holding too much cash usually implies lower profitability. That is especially true if the company is paying interest on debt while carrying cash.

A low cash ratio might signal cash flow problems, but also might indicate that the company is aggressively managing its assets for growth. A higher cash ratio provides security that the company can cover its short-term debts, but also might suggest that the company is not pursuing growth.

What is a liquidity crisis?

A liquidity crisis is a lack of access to cash. A company might face a liquidity crisis on its own, or a liquidity crisis might spread through an entire economic system.

When a company faces a liquidity crisis, it means that its cash conversion cycle (the process of investing in materials, parts, and inventory, which are later sold as finished products) is out of sync with its cash needs. Companies can usually manage these types of cash flow problems with short-term debt.

The term liquidity crisis sometimes refers to a more widespread problem in an economy. In effect, a sudden reduction in the value of marketable securities creates an adverse feedback loop — in which a collapse in price results in fewer current assets, which implies less liquidity and more potential defaults.

To compensate, a company might try to sell its marketable securities to raise cash. But, that just exacerbates the problem, driving prices even lower. Meanwhile, access to short-term debt dries up as defaults increase. Consequently, the problem can spread through the system, creating liquidity issues — even for companies that previously had strong ratios.

What is the difference between solvency ratios and liquidity ratios?

A solvency ratio measures a company’s long-term financial health; liquidity ratios signal its short-term ability to pay its bills. Both are financial ratios that help determine a company's strength, which can be calculated from its financial statements.

When a company is insolvent, it can’t pay off its debts. That might mean the company ends up defaulting on its loans and possibly declaring bankruptcy. Liquidity issues are not as directly tied to bankruptcy risk. Low liquidity might just indicate that the company needs to borrow money until it sells its inventory. In short, solvency ratios are long-term measures, while liquidity ratios are cash flow measures.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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