Liquidity Ratio Analysis Example & Formula

Liquidity ratios are essential metrics that assess a company's ability to meet its short-term obligations. These ratios are key indicators of financial health, particularly in terms of a company’s capacity to cover its current liabilities without encountering significant financial stress. Liquidity ratios evaluate whether a company has enough liquid assets available to pay off its short-term liabilities and whether it can continue its operations smoothly without having to borrow or raise capital. Here, we will delve into six crucial liquidity ratios: the current ratio, quick ratio, interest coverage ratio, gearing ratio, cash ratio, and operating cash flow ratio. These ratios are widely used by investors, creditors, and analysts to evaluate the short-term financial stability of a business.

The current ratio, also known as the working capital ratio, is one of the most fundamental liquidity ratios used to assess a company’s ability to meet its short-term obligations. It is calculated by dividing a company's current assets by its current liabilities. Current assets typically include cash, accounts receivable, and inventory, while current liabilities consist of debts and obligations that need to be settled within a year, such as short-term loans, accounts payable, and accrued expenses. A current ratio greater than one indicates that the company has more current assets than current liabilities, which means it is likely to be able to meet its short-term obligations. A ratio of less than one suggests that the company may have trouble paying off its short-term debts, as it lacks sufficient liquid assets to cover them. For example, a current ratio of 2:1 means that the company has two dollars in current assets for every dollar in current liabilities, which generally signifies a healthy liquidity position. However, an excessively high current ratio can indicate inefficiency, where the company may be holding too much inventory or receivables, which could otherwise be used more effectively.

The quick ratio, also known as the acid-test ratio or quick assets ratio, is a more stringent measure of liquidity than the current ratio. It refines the current ratio by excluding inventory from current assets because inventory is not as easily convertible into cash as other current assets such as cash itself, accounts receivable, or short-term investments. The quick ratio is calculated by subtracting inventory from current assets and then dividing the result by current liabilities. The reasoning behind excluding inventory is that, in the event of a financial emergency, it may not be possible to quickly sell off inventory to raise cash without a significant loss in value. Therefore, the quick ratio provides a clearer picture of a company’s ability to meet its short-term obligations with the most liquid assets at its disposal. A quick ratio greater than one suggests that the company has sufficient liquid assets to cover its current liabilities without relying on inventory sales. A ratio of less than one, on the other hand, may signal liquidity problems, as it suggests that the company may struggle to pay its bills without needing to liquidate inventory, which may take time and could result in a financial loss.

The interest coverage ratio is a measure of a company's ability to pay interest on its outstanding debt. It is calculated by dividing the profit before tax (PBT) by the interest charges on debt. This ratio indicates how many times a company can cover its interest expenses with its pre-tax earnings. A higher interest coverage ratio suggests that the company is in a strong position to meet its interest obligations, while a low ratio implies that the company may have difficulty covering its interest payments, potentially leading to financial distress or a higher risk of default. For instance, if a company has an interest coverage ratio of 5, it means that the company can cover its interest payments five times over with its pre-tax income. The interest coverage ratio is especially important for companies with significant debt, as it helps to evaluate their ability to sustain their operations while servicing debt. A ratio of less than 1.5 is often considered a red flag, indicating potential financial strain or trouble in covering interest payments, which could lead to solvency issues.

The gearing ratio is a financial metric that assesses the proportion of a company’s capital that is financed through debt relative to equity. It is calculated by dividing long-term liabilities by equity shareholders' funds. The gearing ratio provides insight into the financial leverage of a company and its dependence on debt for funding its operations. A high gearing ratio indicates that a company is heavily reliant on debt to finance its operations, which increases financial risk, especially during periods of economic downturn or rising interest rates. A low gearing ratio suggests that the company is more reliant on equity funding, which can be seen as a safer position, as it reduces the financial risk associated with high debt levels. However, while a low gearing ratio indicates lower risk, it may also suggest that the company is under-leveraged and not taking advantage of the potential for greater returns that debt financing could provide. The gearing ratio is particularly important for businesses in capital-intensive industries, where large investments are needed to fund growth, but it can be used across all sectors to assess a company’s debt risk.

The cash ratio is one of the most conservative liquidity ratios, as it only considers a company’s most liquid assets—cash and cash equivalents—in relation to its current liabilities. It is calculated by dividing cash and cash equivalents by current liabilities. This ratio is extremely important because it provides insight into a company's ability to pay off its short-term obligations without needing to sell inventory or rely on accounts receivable. A cash ratio greater than one suggests that the company has enough cash on hand to cover its current liabilities in full. A ratio of less than one implies that the company does not have enough cash reserves to cover its short-term obligations and may need to rely on other assets or financing options to meet its liabilities. However, like the current ratio, an excessively high cash ratio can indicate that the company is not effectively utilizing its cash reserves to generate returns, instead holding it idle, which could be detrimental to overall profitability. The cash ratio is especially relevant in industries where immediate liquidity is critical, such as financial institutions or companies that operate in markets with high volatility or risk.

The operating cash flow ratio is another key liquidity metric that evaluates a company’s ability to meet its current liabilities with its operating cash flow. It is calculated by dividing operating cash flow by current liabilities. Operating cash flow refers to the cash generated from a company’s core business activities, excluding non-operating sources of income such as financing or investing activities. This ratio provides insight into whether the company is generating enough cash from its operations to meet its short-term obligations, without relying on external financing or the sale of non-current assets. A high operating cash flow ratio is a positive sign, indicating that the company’s operations are generating sufficient cash to cover its liabilities. A low operating cash flow ratio, however, may indicate that the company is not generating enough cash from its core activities, which could lead to liquidity problems, especially if the company is heavily reliant on external funding to meet its obligations.

In conclusion, liquidity ratios are vital tools for assessing a company’s ability to meet its short-term financial obligations. Each of the ratios discussed in this essay—current ratio, quick ratio, interest coverage ratio, gearing ratio, cash ratio, and operating cash flow ratio—provides a unique insight into a company's liquidity position and financial stability. These ratios help investors, creditors, and management understand how effectively a company can convert its assets into cash to cover its liabilities and maintain smooth operations. By monitoring these ratios, stakeholders can gauge the company’s financial health, assess its risk level, and make informed decisions about investment, lending, or management strategies. Ultimately, liquidity is a key factor in ensuring a company’s sustainability and long-term success in the ever-changing business environment.

List of common liquidity ratios and formulas:

1) Current ratio (also known as working capital ratio)
= Current Assets / Current Liabilities
2) Quick ratio, in times (also known as acid test ratio or quick assets ratio)
= (Current Assets - Stock) / Current Liabilities
3) Interest Coverage = Profit Before Tax / Interest Charge
4) Gearing ratio = Long Term Liabilities / Equity Shareholders' Funds
5) Cash Ratio = Cash / Current Liabilities
6) Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities

Example:
Calculate the working capital, acid test and gearing ratios, given the following figures:
Debtors: $2,000
Creditors: $5,000
Bank: $11,000
Cash: $1,000
Closing stock: $6,000
Opening stock: $7,000
Total Capital and Reserves: $25,000
Long term loan: $15,000

Solution:

Current assets = debtors + bank + cash + closing stock = 2000 + 11000 + 1000 + 6000 = $20,000

Working capital ratio = 20,000 / 5,000 = 4 (This means that current assets are 4 times current liabilities)

Acid test ratio = (20,000 - 6,000) / 5,000 = 2.8 (This means that current assets in liquid form are 2.8 times current liabilities)

Equity Shareholders' Funds = Total Capital and Reserves + Long term Liabilities = 25000 + 15000 = $40,000

Gearing ratio = 15,000 / 40,000 = 0.375