Financial Ratio to Assess Liquidity (with Example)

Liquidity refers to a company’s ability to meet its short-term financial obligations as they fall due. It is a vital aspect of financial health because a business that lacks liquidity may struggle to pay its bills, suppliers, employees, or other financial commitments, which could lead to insolvency. Assessing liquidity involves evaluating whether a company has sufficient cash, or assets that can be quickly converted into cash, to meet its short-term liabilities. Financial ratios are crucial tools used to analyze a company’s liquidity, as they provide insights into how well a firm can meet its obligations without jeopardizing its operations. The main financial ratios used to assess a company’s liquidity are the current ratio, quick ratio, average credit given, average credit taken, and borrowing ratio.

The current ratio is the most common financial ratio used to evaluate liquidity. It measures the relationship between a company’s current assets and its current liabilities. Current assets are assets that are expected to be converted into cash, sold, or consumed within one year or within the company’s operating cycle, whichever is longer. They include cash, accounts receivable, inventory, and other short-term assets. On the other hand, current liabilities are obligations that must be settled within a short period, usually within one year, such as accounts payable, short-term loans, wages payable, or taxes payable. A high current ratio suggests that the company has sufficient short-term assets to pay off its short-term obligations, indicating good liquidity. Conversely, a low current ratio may suggest that a company might face difficulties in meeting its financial commitments.

The quick ratio, sometimes referred to as the acid-test ratio or liquid ratio, is another essential financial ratio used to evaluate liquidity. Unlike the current ratio, the quick ratio excludes inventory from current assets because inventory is less liquid compared to cash, receivables, or other short-term assets. Inventory may take time to convert into cash, especially if market demand is low or supply chain disruptions occur. By subtracting inventory from current assets and comparing the remaining assets to current liabilities, the quick ratio provides a more stringent measure of a company’s ability to meet its short-term obligations. A higher quick ratio indicates that a company has strong liquidity and can respond quickly to its financial obligations. Conversely, a low quick ratio may signal potential liquidity problems.

In addition to the current and quick ratios, financial analysis also utilizes average credit given and average credit taken to examine a company’s credit policies and liquidity. Average credit given measures how long it takes a company to collect receivables from its customers. It is calculated by comparing the average accounts receivable to net credit sales over a given period and then converting that figure into days. A shorter average credit given indicates that a company collects payments from customers relatively quickly, which can enhance cash flow and liquidity. Conversely, a longer average credit given may indicate that a company is offering extended credit terms or struggling to collect payments from customers.

On the flip side, average credit taken measures how long it takes a company to pay its suppliers or creditors. This ratio compares the average accounts payable to net credit purchases over a specific time period and expresses it in days. A longer average credit taken suggests that a company maintains favorable credit terms with suppliers and can delay cash outflows, thereby improving liquidity. Conversely, a shorter average credit taken may indicate that a company is paying off its obligations quickly, which could lead to reduced cash reserves.

The borrowing ratio, while not exclusively a liquidity ratio, is also used to analyze a company’s financial structure and liquidity. The borrowing ratio compares a company’s total borrowings to its net worth (equity). Borrowings include loans, bonds, or other forms of debt financing. A higher borrowing ratio indicates that a company relies heavily on debt financing to meet its obligations, which can increase risk and strain liquidity, particularly during periods of financial stress. Conversely, a lower borrowing ratio suggests a lower dependency on debt and, therefore, a lower risk of liquidity crises. However, a company must strike a balance between equity financing and debt financing, as debt allows companies to grow but also increases their financial obligations.

These financial ratios are interconnected and serve distinct purposes in evaluating a company’s liquidity. The current ratio offers a broad overview of a company’s ability to meet its short-term obligations using its current assets, while the quick ratio provides a stricter measure by excluding inventory from consideration. Both ratios focus on the company’s ability to generate cash to pay current liabilities. Meanwhile, average credit given and average credit taken examine how effectively a company manages its credit policies, customer receivables, and supplier payments. These ratios help determine whether a company can balance cash inflows and outflows by maintaining favorable credit terms. The borrowing ratio, while related to a company’s financial leverage, can offer additional insights into how much debt a company has taken on to finance operations and how that may affect its ability to maintain liquidity.

Assessing a company’s liquidity is critical for both investors and creditors. Investors want assurance that a company has enough cash or liquid assets to sustain its operations and pay dividends. Similarly, creditors and lenders need to know that a company can meet its obligations, including repayment of principal and interest. Financial ratios, such as those used to measure liquidity, provide a snapshot of a company’s financial health and operational stability. They are essential tools that investors, creditors, and financial analysts use to forecast the company’s ability to survive financial challenges, invest in growth opportunities, or weather economic downturns.

Liquidity ratios must, however, be interpreted carefully and in conjunction with other financial data and industry trends. For instance, a high current ratio may not always signify strong liquidity if a company’s current assets are tied up in inventory or accounts receivable rather than being readily available as cash. Similarly, short-term borrowing needs and other operational factors can affect liquidity ratios over time. For this reason, analyzing trends in these ratios over multiple periods and benchmarking them against competitors within the same industry is vital to gaining a complete and accurate understanding of a company’s liquidity position.

It is also important to consider the nature of the company’s business model. Some industries, such as retail or manufacturing, may naturally operate with higher inventory levels, while others, like technology or services, may depend on accounts receivables or other liquid assets to maintain their operations. Consequently, comparing a company’s liquidity ratios to industry standards is critical for proper analysis.

In conclusion, financial ratios are essential tools used to assess a company’s liquidity, which is a measure of its ability to meet short-term obligations and operational costs. The current ratio and quick ratio provide insights into a company’s ability to convert assets into cash quickly to meet financial demands. Average credit given and average credit taken measure the company’s credit policies and how effectively it manages receivables and payables. Meanwhile, the borrowing ratio examines the extent of reliance on debt financing and the resulting implications for liquidity risk. Understanding these ratios allows investors, creditors, and financial analysts to assess a company’s financial flexibility, operational stability, and ability to manage short-term financial obligations. They are integral to making informed decisions about investment, lending, and financial planning. However, these ratios must always be analyzed in context, considering industry standards, market conditions, and trends over time to ensure a well-rounded evaluation of a company’s liquidity position.

Below are the main financial ratios to assess liquidity:

1) Current ratio = Current Assets / Current Liabilities
2) Quick ratio = (Current Assets - Stock) / Current Liabilities
3) Average credit given = (Average Debtors / Net Credit Sales) * 365 Days
4) Average credit taken = (Average Creditors / Net Credit Purchases) * 365 Days
5) Borrowing Ratio = Total borrowings / Net worth

Example:
Calculate the relevant liquidity ratios with the following information:
Debtors: $30,000
Creditors: $37,000
Proposed dividends: $5,000
Bank: $8,000
Cash: $2,000
Stock: $10,000
Capital at end: $350,000
Mortgage loan: $300,000

Solution:
(1) Current ratio = 50,000 / 42,000 = 1.19
This means that current assets are 1.19 times current liabilities.

(2) Quick ratio = (50,000 - 10,000) / 42,000 = 0.95
This means that liquid assets are 0.95 times current liabilities.

(3) Borrowing Ratio = Total borrowings / Net worth = 300,000 / 350,000 = 0.86 (i.e., 86% geared)

Workings:
Current assets = stock + debtors + bank + cash = 10,000 + 30,000 + 8,000 + 2,000 = $50,000
Current liabilities = creditors + proposed dividends = 37,000 + 5,000 = $42,000