Liquidity Ratio - Formula, What It Is, Meaning, Types, Examples, & Analysis

What is a Liquidity Ratio?

A liquidity ratio is a financial ratio used to assess a company's ability to pay its short-term liabilities using its short-term assets.

Short-term liabilities refer to obligations that need to be settled within one year. These include trade creditors, short-term loans, accrued expenses, and bills payable.

Current assets typically comprise cash, bank balance, accounts receivable, inventories, and short-term investments.

Liquidity ratios measure these current assets against the current liabilities. A higher liquidity ratio indicates that a company is in a better position to fulfill its short-term obligations. However, an excessively high liquidity ratio does not necessarily indicate strong financial performance.

Importance of Liquidity Ratio

Liquidity ratios are very important, as they provide an instant insight into the company's short-term financial position. The business must have sufficient liquidity to continue its operation smoothly. A profitable business might face difficulties even if it is unable to pay its liabilities on time.

There are many benefits of the liquidity ratios.

First of all, liquidity ratios help management assess whether there is sufficient money to meet future obligations. If the liquidity ratio is low, management can take steps such as accelerating the collection of accounts receivable, cutting down on unnecessary expenses, or obtaining short-term financing.

Secondly, liquidity ratios are used by creditors to find out whether the business will be able to pay them on time. The suppliers may be more than willing to extend credit facilities to the business with a good liquidity position.

Lastly, banks and other lenders may consider liquidity ratios before lending any money.

Types of Liquidity Ratios

There are various liquidity ratios, but the commonly used ones are:

• Current Ratio
• Quick Ratio
• Cash Ratio
• Net Working Capital Ratio

Current Ratios

The current ratio is one of the most commonly used liquidity ratios. It compares a business’s current assets with its current liabilities.

The formula is:

Current Ratio = Current Assets ÷ Current Liabilities

Let us assume that a company has current assets of ₹2,00,000 and current liabilities of ₹1,00,000.

Current Ratio = ₹2,00,000 ÷ ₹1,00,000

Current Ratio = 2:1

In the above scenario, the business has ₹2 of current assets for every ₹1 of current liabilities.

While a ratio of 2:1 is often considered comfortable in many traditional textbook illustrations, there is no ideal ratio that applies to all businesses. What is appropriate will depend on the industry, nature of the business, and economic factors.

A high current ratio indicates a better financial position in terms of meeting short-term commitments. On the other hand, an extremely high current ratio may indicate that a significant amount of money is tied up in inventory, accounts receivable, or other current assets. A low current ratio may indicate that the company could face difficulties in meeting its short-term liabilities.

Quick Ratio

The quick ratio is also known as the acid-test ratio. This ratio is considered a more stringent liquidity test than the current ratio.

Inventory is excluded from current assets when calculating the quick ratio. Inventory may not be readily sold, and selling it quickly may sometimes require offering a discount. The formula is as follows:

Quick Ratio = Quick Assets ÷ Current Liabilities

Quick assets usually consist of cash, bank balance, short-term investments, and accounts receivable.

Another formula is as follows:

Quick Ratio = (Current Assets - Inventory - Prepaid Expenses) ÷ Current Liabilities

Assuming that a firm has the following figures:

• Current assets = ₹300,000
• Inventory = ₹100,000
• Prepaid expenses = ₹20,000
• Current liabilities = ₹150,000

Quick assets = ₹300,000 - ₹100,000 - ₹20,000 = ₹180,000

Quick Ratio = ₹180,000 ÷ ₹150,000

Quick Ratio = 1.2:1

This implies that the firm has ₹1.20 of relatively liquid assets for every ₹1 of current liabilities. The quick ratio is important because it provides a better idea of whether the company can meet its short-term obligations without relying much on selling inventory.

Cash Ratio

The cash ratio is another form of liquidity ratio that is more conservative than the quick ratio. The cash ratio considers cash and cash equivalents and some highly liquid assets when evaluating the company’s capacity to pay off its current liabilities.

The formula is:

Cash Ratio = (Cash + Cash Equivalents + Short-Term Investments) ÷ Current Liabilities

For instance, if a company has ₹50,000 cash and cash equivalents, ₹30,000 short-term investments, and ₹100,000 current liabilities:

Cash Ratio = (₹50,000 + ₹30,000) ÷ ₹100,000

Cash Ratio = 0.80:1

This means that the firm has ₹0.80 in cash and near cash per ₹1 of current liabilities.

The cash ratio is important in instances where there is a need to determine the capability of a company in meeting its short-term liabilities using readily available resources. However, companies do not need to have enough cash to pay their current liabilities, as they also generate cash from sales and from other activities.

Net Working Capital Ratio

Working capital is calculated as the difference between current assets and current liabilities.

The calculation is as follows:

Working Capital = Current Assets - Current Liabilities

When current assets are ₹250,000 and current liabilities are ₹150,000:

Working Capital = ₹250,000 - ₹150,000

Working Capital = ₹100,000

Working capital represents the short-term resources remaining when current liabilities are taken into consideration.

The net working capital ratio can also be calculated as follows:

Net Working Capital Ratio = Net Working Capital / Current Assets

This ratio can assist analysts in understanding the relationship between a firm’s short-term resources and its short-term liabilities.

Advantages of Liquidity Ratios

There are many advantages associated with the liquidity ratios.

• Helps Measure Short-Term Financial Strength: The key benefit is that liquidity ratios indicate whether a company is in a position to meet its short-term liabilities.
• Useful for Creditors: Creditors and suppliers can use liquidity ratios to evaluate the risks involved in lending money to a firm.
• Helps Management Make Decisions: Company managers can use liquidity information to plan cash requirements, manage working capital, and control short-term borrowing.
• Supports Investment Decisions: Investors can use liquidity ratios along with other ratios, such as profitability and efficiency ratios, when making investment decisions.
• Easy to Calculate: Liquidity ratios are easy to calculate since the required data is usually found on the balance sheet or statement of financial position.

Limitations of Liquidity Ratios

• Accounting Figures: Liquidity ratios are mostly calculated using accounting numbers, which do not reveal the true value or the true timing of the assets and liabilities.
• Industry Differences: Different industries have different normal liquidity levels. A ratio suitable for one industry may not be suitable for another.
• Seasonal Changes: Liquidity ratios can be influenced by seasonal factors. For instance, companies like retailers tend to keep more inventory during holidays.
• High Ratio ≠ Good Performance: A high liquidity ratio does not necessarily indicate success. It means that there is excess cash that is not used in productive investment.
• Low Ratio ≠ Financial Trouble: A low liquidity ratio does not necessarily mean that the company is facing difficulties. Some businesses receive cash from customers very quickly and can operate successfully with lower liquidity.