Liquidity ratios provide information about the liquid situation and stability of a company. We show you here which different ratios there are, how to calculate them and what the ideal values are.
Liquidity ratio: Meaning
Liquidity ratios measure the liquidity of a company. They provide insight into a company's ability to repay its debts and other liabilities out of its liquid assets.
Liquidity includes all assets that can be converted into cash quickly and cheaply. In addition to cash and account balances, this also includes securities that can be sold quickly, such as shares, and investments with short maturities, such as treasury bills. Accounts receivable and inventories are also included in liquidity under certain circ*mstances.
Liquidity ratio: Formula
There are different liquidity ratios, so there are also different formulas. Each ratio looks at liquidity from a slightly different angle. So, depending on what you are interested in, you can choose the appropriate formula.
Current ratio
The current ratio compares current assets with current liabilities. Current assets include cash, marketable securities, accounts receivable and inventories. Current liabilities include all short-term liabilities, i.e. those that have to be paid within one year or less.
Current ratio = Current assets / current liabilities x 100
Multiplying by 100 gives the current ratio as a percentage. It indicates how well a company is able to repay its current liabilities with its current assets. The higher the current ratio, the more funds the company has available and the better its liquid situation.
If the current ratio is greater than 100%, it means that the company has more current assets available than it has current liabilities. This is the standard case for a healthy company.
If the current ratio is below 100%, this means that the company cannot repay its current liabilities with its current assets. However, this need not be a cause for concern, as long as this situation does not become the norm.
Quick ratio
With the quick ratio, the same variables are considered as with the current ratio, only inventories are left out of the calculation. The formula for the quick ratio then looks like this:
Quick ratio = (Cash + marketable securities + accounts receivables) / current liabilities x 100
Marketable securities include, for example, securities or bonds that can be sold quickly.
The quick ratio indicates the company's ability to service its short-term liabilities from the majority of its liquid assets.
Absolute liquidity ratio or cash ratio
In the absolute liquidity ratio or cash ratio, accounts receivable and inventories are not included in the calculation:
Cash ratio = (Cash + marketable securities) / current liabilities x 100
This takes an even closer look at the liquidity situation, as only the most liquid funds are compared to the current liabilities. These are the liquid funds that are available to the company very quickly, which is an advantage if an unexpected higher sum has to be paid at short notice.
Liquidity ratio: Example
A company has the following values in its balance sheet:
- Cash: £50,000
- Marketable securities: £20,000
- Accounts receivable: £100,000
- Inventories: £30,000
- Current liabilities (accounts payable): £80,000
We can now calculate the different liquidity ratios using the formulas from the previous section:
Current ratio = (£50,000 + £20,000 + £100,000 + £30,000) / £80,000 x 100 = 250% Quick ratio = (£50,000 + £20,000 + £100,000) / £80,000 x 100 = 213%Cash ratio = = (£50,000 + £20,000) / £80,000 x 100 = 88%.
Liquidity ratio analysis & interpretation
By calculating the various liquidity ratios as in the example above, the cash situation of the company can be analysed. The current ratio in the example is 250%. This means that the company has more current assets available than it has short-term liabilities to service - a positive sign.
However, if liquidity is interpreted more narrowly and the quick ratio is considered, the ratio is lower, but in the example it is still sufficient at 213%. The company can pay its liabilities in full within a short time without having to liquidate assets from inventories.
The cash ratio is even narrower and only includes the absolute most liquid funds. The company could still service 88% of its liabilities, but would have to liquidate part of its inventories or wait for a longer period of time until income from accounts receivable arrives.
What is a good liquidity ratio?
One might think that a company should aim for the highest possible liquidity ratios. However, this is not the case. For the current ratio, a benchmark of 200% is considered solid. This means that the company always has sufficient current assets available to meet its short-term liabilities.
If the current ratio were only 100%, this would mean that the company can just about service its liabilities with its current assets. An unexpectedly high bill could then quickly bring the company into payment difficulties.
A value of 100% is targeted for the quick ratio. This is to ensure that the company can cover all its liabilities without having to liquidate assets from inventories.
For the cash ratio, 20% is a good benchmark. Although this means that you could only cover a small part of your liabilities with the most liquid funds, companies accept this risk for growth reasons. If the cash ratio is very high, it means that a lot of cash is lying around unused and cannot be used for investments and growth.
We summarise the benchmarks for liquidity ratios:
- Current ratio: 200%
- Quick ratio: 100%
- Cash ratio: 20%
