Understanding Liquidity Ratios

Financial ratios are mathematical relationships between two entities, accounts, or categories. These relationships between the various accounts in the financial statements help all the concerned stakeholders to understand the performance of a company including those areas that need more improvement.

Financial ratios are the common indicators used to scrutinize a company’s financial health. Not only are these ratios simple to calculate but also help in comparing companies across varying sectors. An analyst uses financial ratios to understand the relationships among various financial statement accounts. These ratios yield information about a company’s ability to meet short-term obligations on time, remain solvent over a longer period of time, manage assets, and operate efficiently.

Liquidity ratios

Liquidity ratios measure the ability of the enterprise to meet its short-term financial obligations in a timely manner. The capability of a company to pay off both its current as well as long-term liabilities is gauged by liquidity ratios. In other words, these ratios help us understand the levels of cash held by a company as well as the ability of the firm to convert other assets into cash to pay off its obligations.

Liquidity ratios measure the relationship of the more liquid assets of an enterprise (which is most easily convertible to cash) to the current liabilities. The most common liquidity ratios are the current ratio and acid test (or quick asset) ratio.

The current ratio is a popular way of measuring liquidity because it is a quick and easy way to express the quantitative relationship between the current assets and current liabilities. It answers the question: ‘How many rupees in current assets are there to cover for each Re 1.00 in the current liabilities?’ To calculate the current ratio, divide current assets by the current liabilities.

Current ratio = current assets/current liabilities

A rule of thumb is that a current ratio close to 2.0 is good but this is a much generalized statement. It is advisable to test the strength of the current ratio by carefully examining the enterprise's accounts receivable and inventory levels. The current ratio should, therefore, be used as a rough indicator and never as an accurate statement of the company's actual ability to pay.

The second most commonly used liquidity ratio is the quick asset ratio, often called the acid test. This ratio presents a more precise liquidity test by considering only the more liquid current assets thereby, excluding inventories, prepaid expenses, and other current assets from the calculation. In this way, the index places greater emphasis on the more immediate conversion of the current assets to provide coverage of short-term obligations. The rule of thumb for a healthy acid test index is 1.0.

Acid test = (cash + near cash assets + trade receivables)/current liabilities

The acid test presumes that trade receivables are more liquid than the inventories. Trade receivables are directly converted to cash while inventories are first converted to trade receivables (if sales are made on a credit basis) and then to cash. In addition, there is some uncertainty of the value at which inventories will be realized, since some items may become damaged, lost, or obsolete.

Let's look at an example and see how the two ratios complement each other

In the above table, Company C has the highest current ratio but it relies on the realization of inventories to cover its short-term liabilities. If it is unable to convert the inventories to cash, it will only have Rs 0.55 (400 – 300 ÷ 180) in quick assets to meet each Re 1.00 of current liabilities.

Company A probably has the best liquidity of all because it does not depend on inventory realisation to meet its debts. Even without selling inventories, it has Rs 1.30 in current assets to meet every Re 1.00 in the current debt.