What Is A Liquidity Ratio? (Definition, Types And Example)

The liquidity ratio is a financial metric which can determine a company's ability to pay off its short-term liabilities. If the value of the ratio is higher, then the margin of safety that the company possesses to cover the debts is also bigger. Learning about the liquidity ratio can help you identify possible financial solutions and determine if a company can clear its debt obligations using its current assets. In this article, we discuss what is liquidity ratio, examine its different types, find out how to calculate various ratios and understand it better with an example.

What is a liquidity ratio?

The answer to the question, 'What is a liquidity ratio?' lies in the assets of an entity and how quickly that entity can turn it into cash. Cash in bank, letters of credit in domestic and foreign currency and securities are some ways a company can use to convert them into cash. Before giving short-term loans to a business, creditors often check their liquidity ratio to determine if they can give credit to the business.

Since liquidity is an enterprise's ability to convert its assets into cash, there is a connection between how much asset value is liquid and what assets a business can liquidate, like cash or stocks. When the value of the liquidity ratio decreases, it means that the business is experiencing problems in meeting short-term liabilities. This affects the volume of the business and its finances. A higher ratio means that chances of recovery in liquidity are better.

Related: What Is Financial Modelling? (With Benefits And Types)

Types of liquidity ratios

Here are the different types of liquidity ratios:

Current ratio

The relationship between current assets and current liabilities describes the current ratio. It is the assessment of general liquidity and is often used to develop analyses for the short-term liquidity of an organisation. To calculate the current ratio, divide the total of the current assets by the total of the current liabilities.

Current ratio = Current assets/Current liabilities

Quick ratio

Also known as acid-test, quick ratio is a more thorough test of liquidity. The quick ratio is an indicator of how quickly an organisation can pay its current liabilities. The bigger this ratio is, the better it is for the organisation. You can exclude the inventory from the quick ratio while calculating it, which you can do by dividing the company's cash or near cash current assets by its total current liabilities.

Quick ratio = (Cash + Marketable securities + Accounts receivable) / Current liabilities

Cash ratio

You can use the cash ratio to compare current assets that a company can change into cash against its current liabilities. The ratio is useful when a company needs quick access to funds to clear its liabilities. To calculate the cash ratio, add cash and marketing securities and divide the result with current liabilities. You may attribute a lower cash ratio to a significant backlog in the accounts receivable.

Cash ratio = (Cash + Marketing securities) / Current liabilities

Times interest earned ratio

Also known as the interest coverage ratio, this type of ratio compares an organisation's accessible income to interest expenses in the future. You may also use this ratio as a solvency ratio to determine the long-term availability of funds for the existing interest. You can calculate this ratio by dividing the earnings before tax and interest with the interest expense. This type of ratio shows the organisation's ability to pay its interests on time.

Times interest earned ratio = Earnings before tax and interest/Interest expense

Days sales outstanding (DSO) ratio

You can use the DSO to measure the amount of time an organisation takes to receive a payment once it completes the sale. A high DSO value means that the organisation is taking a long time to secure payment. You can calculate this ratio by dividing the average accounts receivable by the per-day revenue. You may calculate this on a monthly, weekly, quarterly or annual basis.

DSO ratio = Average accounts receivable/Revenue per day

Inventory turnover ratio

The number of times an organisation sells its inventory and replaces it over a period represents the inventory turnover ratio. To determine the inventory turnover, divide the cost of goods sold by the average inventory. A lower ratio implies fewer sales and surplus inventory. The organisation may adopt strategies to fix the low inventory turnover ratio since the quality of products may deteriorate when kept in a warehouse for longer periods.

Inventory turnover ratio = Cost of goods sold/Average inventory

Related: Scope Of MBA In Finance (With Jobs And Salary Information)

Difference between liquidity ratios and solvency ratios

Here are some important differences between liquidity ratios and solvency ratios:

• Difference in purpose: The purposes of liquidity ratios and solvency ratios are different. While you can use the liquidity ratios to gauge a company's ability to pay off its debt obligations, you can use the solvency ratio to measure an organisation's ability to pay off long-term liabilities.

• Unmanageable debt against manageable debt: Companies employ liquidity ratios to assess how much cash they can get to make their payments. Companies who use solvency ratios have ample funds available with them and without using their assets, they are able to pay off their debts.

• Low risk as opposed to high risk: People consider liquidity to possess low risk since it intends to cover all short-term obligations in a small time frame. Solvency may possess a high risk because it forecasts that an organisation may continue to operate using the money it has.

• Usable ratios: Internal company officials and creditors make use of current or quick ratios to determine the assets of an organisation. A debt-equity or times interest earned ratio is used to measure the organisation's solvency or long-term operation expectancy.

Understanding the liquidity ratio through an example

Here is how you may better understand the liquidity ratio with the help of an example:

As Em and Sons receive raw materials and other supplies from vendors, the expectation is to receive payment in full once they complete the work for their clients. Towards the end of the fiscal year, when the company is about to complete seven projects, it is essential that they have enough money to repay the loans they borrowed from the vendors for materials. They are aware that they do not have sufficient revenue to pay back their vendors.

So now, they have taken a decision to liquidate several assets into cash. They have selected the quick ratio to determine if they can pay their vendors. Em and Sons have found out that they have ₹8,00,000 in existing liabilities. They have ₹2,00,000 in cash, ₹2,00,000 in marketable securities and ₹4,00,000 in accounts receivable. Using the quick ratio, they can now assess their company's assets and liabilities.

• Cash: ₹2,00,000

• Marketable securities: ₹2,00,000

• Accounts receivable: ₹4,00,000

Quick ratio = (2,00,000 + 2,00,000 + 4,00,000) / 8,00,000 = 1

By adding ₹2,00,000 in cash, ₹2,00,000 in marketable securities and ₹4,00,000 in accounts receivable and dividing it by current liabilities market at ₹8,00,000, they determine their quick ratio, which is 8,00,000/8,00,000. The value of the quick ratio here is 1:1.

By using the quick ratio equation, We Are Em and Sons determines that they have sufficient current assets that they can liquidate into cash to equal and pay off their current liabilities.

Related: Basics of Accounting - Terminology, Principles And Concepts

Ratios other than the liquidity ratios

Here are some other ratios apart from liquidity ratios:

Asset management ratios

Asset management ratios include the fixed asset turnover ratio, which is a measure of how productively an organisation uses its equipment and infrastructure. You can calculate it by dividing a company's total sales by its net fixed assets. The asset management ratios also include the total assets turnover ratio, which is a measure of how efficiently a firm uses its assets.

Debt management ratios

Debt management ratios include the debt service coverage ratio, which is a measure of an organisation's potential to service its debt obligations. You can calculate it by dividing a company's cash available for debt service by the cash needed for debt service. Apart from this ratio, debt management ratios also include times interest earned ratio, which is an organisation's ability to pay its interest payments on time and earnings before interest, taxes, depreciation and amortisation coverage ratio, which depicts an organisation's ability to settle its fixed financial charges.

Profitability ratios

Profitability ratios include profit margin on sales, which determines an organisation's capacity of sales to generate net income. The profitability ratios also include basic earning power, which shows the earning ability of a company's assets before the effects of taxes and interest. These ratios also include return on investment, earnings per share and return on equity.

Market value ratios

Market value ratios include price/earnings ratio, which shows the price investors are ready to pay per rupee of a company's earnings. You can calculate this by dividing an enterprise's earnings before interest and taxes by its total assets. These ratios also include the price/cash flow ratio, which shows the price investors are ready to pay per rupee of net cash flow of the firm and the market-to-book ratio, which is the market value of a company divided by its book value.