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What is Liquidity Ratio: Meaning, Formula and How to Calculate
One of the primary concerns that every investor looks after to sort out is the liquidity of the company. Liquidity, in general, means that the assets in which you have invested give you immediate access to your money whenever you need it. We all look for this in a company before making an investment, whether as a shareholder or as a supplier.
Now, the important question arrives, before investing, how to know whether such a company is liquid enough or not? To accomplish the same purpose of investing, you need to calculate a ratio named liquidity ratio.
What is the liquidity ratio?
The liquidity ratio is a financial metric that will help you judge a company's ability to pay its debt. It can also be the time a company will take to repay its debt from its due date. In simple words, calculating the liquidity ratio means knowing how quickly a company can convert its current assets into liquid cash. The liquidity ratio is also known as the short-term solvency ratio. The prime reason of this ratio is to let investors know that a company does not struggle with paying its short-term dues.
Types of analysis through liquidity ratio
Two types of analysis can be done using liquidity ratios to understand the company better and make informed investing or collaborating decisions. These two analyses are:
- Internal analysis
- External analysis
Let's understand both one by one.
By using the liquidity ratio, you can do an internal analysis to know whether a company can perform better than its historical performance. For example, if you want to know whether a company has improved itself over time in terms of liquidity or not. You can compare liquidity ratios from the past 5-10 years. If the liquidity ratio of the company has increased, it means the company is improving. If not, then it means the company's management needs to be more efficient in maintaining the operating cycle of the company.
By using liquidity ratios, you can do external analysis to know whether the company can be solvent compared to other companies in the same industry and at the same level. For example, you need clarification on two companies, company A and company B. Both companies are similar in terms of business life cycle and industry-wise. The companies with higher liquidity are preferable and considerable ones than lesser liquidity companies.
Types of liquidity ratios
There are four main types of liquidity ratios through which you can decide whether the companies can maintain their short-term solvency.
The current liquidity ratio measures the ability of a company to pay off its current liability by using its current assets.
Current liabilities includes:
- short-term loan,
- bank overdraft,
Current assets mean:
- marketable securities,
- Prepaid expenses.
The formula of the current ratio is as follows:
Current assets/current liabilities.
You can consider inventory as a current asset, but it generally takes time to convert into liquid cash, equal to the time it takes to make a sale. The quick liquidity ratio helps you to understand when the company will be able to liquidate its assets by using its quick liquid assets. The same concept is applied to prepaid expenses as well. Prepaid expenses do not bring any cash inflow.
So, the formula for the quick liquidity ratio becomes;
Current assets - Inventory- prepaid expenses / current liabilities
Absolute liquidity ratio
This ratio calculates the company's overall liquidity. This ratio solely considers the company's cash on hand and marketable securities. Only short-term liquidity in the form of cash, marketable securities, and current investments is tested by this ratio.
Hence, the formula would be as follows:
Cash + Marketable Securities / Current Liability
Basic defence ratio
The defence liquidity ratio is different from other types of liquidity ratios. It measures the number of days it takes to cover its cash expenses of working capital without the help of additional financing tools available to the company.
The formula for calculating such type of liquidity ratio is as follows:
Cash + debtors + marketable securities / operating expenses + interests + taxes
These are the different types of liquidity ratios you can use to ascertain the company's liquidity level. All these various types of liquidity help an investor analyze a company's liquidity at different difficulty levels. Businesses need to be liquid enough to meet their expenses and maintain their operations optimized. The company can maintain its payrolls, pay off its creditor's bills, and pay their taxes and interest (if any loan is taken).
When talking about the investor's perspective, it is beneficial to look at the liquidity ratio before making investment decisions, as it will help to understand if the company will be able to grow by maintaining current operations and if it will be able to maintain enough profits to distribute dividends.
From the perspective of creditors, before collaborating with the company, you, as a creditor, need to know that the company is financially sound enough to pay your dues on time. You will be more than happy to work with a company that is loyal to its creditors and deliver on time.