Liquidity Ratios Calculation, Formula, Meaning Explained

Assessing a firm’s liquidity is an important task every investor and manager should do before anything; but how? With different liquidity ratios, anyone can gain an accurate understanding of a company’s financial health and overall situation within minutes—read on to find out everything about these powerful formulas.

How Do Liquidity Ratios Work?

A group of financial indicators known as liquidity ratios is used to assess a debtor's capacity to settle current debt commitments without the need for outside funding.

The measurement of indicators such as the current ratio, quick ratio, and days sales outstanding enables us to calculate liquidity ratios, which assess a company's capacity to satisfy debt obligations as well as its margin of safety.

Main Takeaways

• This group of financial indicators, known as liquidity ratios, is used to assess a debtor's capacity to settle current debt commitments without the need for outside funding.
• The current ratio, quick ratio, and days sales outstanding are common liquidity ratios.
• While solvency ratios are focused on a longer-term ability to pay off ongoing debts, liquidity ratios assess a company's capacity to meet short-term commitments and cash flows.

Liquidity Ratios Simply Explained

The capacity to swiftly and reasonably turn assets into cash is known as liquidity. The best application of liquidity ratios is in comparison form where both internal and external analyses may be used.

For instance, employing numerous accounting periods that are reported using the same accounting standards is necessary for the internal study of liquidity ratios.

Analysts can follow changes in the firm by comparing historical periods to current operations. A greater liquidity ratio, in general, indicates that a business is more liquid and has better coverage of its outstanding loans.

As an alternative, the external analysis compares the liquidity ratios of several businesses or an entire sector. When setting benchmark targets, it is helpful to compare the company's strategic orientation to its rivals.

Since different firms require different funding arrangements, liquidity ratio research may not be as useful when comparing industries. Comparing firms of various sizes and profiles using liquidity ratio analysis is less effective.

Read more about Essential Accounting Terms Everyone Should Know.

Liquidity Ratios: Different Types And Calculations

Current Ratio Calculation Simply Explained

The current ratio evaluates a company's capacity to cover its entire current obligations with current assets, which include cash, accounts receivable, and inventory. The better the ratio, the more liquid the firm is:

Current Assets / Current Liabilities = Current ratio.

Quick Ratio Calculation Simply Explained

The quick ratio removes inventory from current assets since it evaluates a company's capacity to pay short-term commitments with its most liquid assets. The acid-test ratio is another name for the following:

Quick Ratio = (C + MS + AR) / CL

• C = Cash & cash equivalents;
• MS = Marketable Securities;
• AR = Accounts Receivable;
• CL = Current Liabilities.

Days Sales Outstanding (DSO)

The average number of days it takes for a business to receive payment after making a transaction is referred to as Days Sales Outstanding (DSO). A high DSO indicates that a business is locking up cash in receivables and takes an excessively long time to collect payment.

Typically, quarterly or yearly calculations are used to determine DSO:

• DSO = Average Accounts Receivable / Revenue Per Day
• Liquidity Ratios: Practical Examples

Let's utilize a few of these liquidity measurements to illustrate how well they may be used to evaluate the financial health of a firm.

Wasslak and Khaiaal are two hypothetical businesses having the following assets and liabilities shown on their balance sheets (figures in millions of SAR). We presume that both businesses are involved in the same industry.

Wasslak

• Current ratio = SAR 60 / SAR 20 = 3.0
• Quick ratio = (SAR 60 – SAR 20) / SAR 20 = 2.0
• Debt to equity = SAR 100 / SAR 30 = 3.33
• Debt to assets = SAR 100 / SAR 150 = 0.67

Khaiaal

• Current ratio = SAR 20 / SAR 50 = 0.40
• Quick ratio = (SAR 20 – SAR 10) / SAR 50 = 0.20
• Debt to equity = SAR 20 / SAR 80 = 0.25
• Debt to assets = SAR 20 / SAR 150 = 0.13

From these ratios, we can conclude a number of things about the financial health of these two businesses.

High levels of liquidity characterize Wasslak. It has SAR 6 in current assets for every Riyal in current liabilities, according to its current ratio. With SAR 4 in assets that can be quickly converted to cash for every SAR of current obligations, it has a fast ratio that indicates good liquidity even after eliminating inventory.

Khaiaal, on the other hand, faces another scenario. With just SAR 0.80 of current assets available to pay every SAR 2 of current obligations, the company's current ratio of 0.4 shows a lack of appropriate liquidity. With just SAR 0.40 in liquid assets for every SAR 2 of current obligations, the quick ratio indicates an even more precarious liquidity situation.

Why Is Liquidity Important For Businesses?

The term "liquidity" describes how quickly or readily money may be raised to cover short-term commitments like bills. Liquid assets include those that can be easily sold, such as bonds and stocks (even though cash is the most liquid of all). Businesses need to retain enough cash on hand to satisfy their expenses and commitments in order to pay their suppliers, make payroll, and maintain day-to-day operations.

Why Do Different Liquidity Ratios Exist?

Fundamentally, all liquidity ratios computed by dividing current assets by current liabilities assess a company's capacity to pay short-term commitments (CL). The quick ratio also includes marketable securities, accounts receivable, and cash equivalents, whereas the cash ratio just considers the amount of cash on hand divided by CL. Note that all current assets are included in the current ratio.

What Takes Place When Ratios Indicate A Firm Is Not Liquid?

If something makes it impossible to satisfy short-term commitments, such as repaying loans and paying workers or suppliers, a liquidity crisis may develop even in healthy organizations. The worldwide credit crunch of 2007–2009 is one recent example of a severe liquidity crisis, during which many businesses were unable to get short-term finance to meet their urgent obligations.

Overall, it is easy to see why liquidity ratios are essential parts of financial analysis. They not only allow management and investors to gain insights about companies’ cash but also their general financial standing—all with just a few simple calculations. If you’re interested in learning more about financial statements and their analyses, check out one of our related articles now—see you there!