What Are Liquidity Ratios?

Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio.

Current liabilities聽are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency.

Key Takeaways

  • Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital.
  • Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding.
  • Liquidity ratios determine a company's ability to cover short-term obligations and cash flows, while solvency ratios are concerned with a longer-term ability to pay ongoing debts.

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Understanding Liquidity Ratios

Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios are most useful when they are used in comparative form. This analysis may be internal聽or external.

For example, internal analysis regarding liquidity ratios involves using multiple accounting periods that are reported using the same accounting methods. Comparing previous time periods to current operations allows analysts to track changes in the business. In general, a higher liquidity ratio shows聽a company is more liquid and has better coverage of outstanding debts.

Alternatively, external analysis involves comparing the liquidity ratios of one company to another or an entire industry. This information is useful to compare the company's strategic positioning in relation to its competitors when establishing benchmark goals. Liquidity ratio analysis may not be as effective when looking across industries聽as various businesses require different financing structures. Liquidity ratio analysis is less effective for comparing businesses of different sizes in different geographical locations.

Common Liquidity Ratios

The Current Ratio

The聽current ratio聽measures a company's ability to pay off its current liabilities (payable within one year) with its current assets such as cash, accounts receivable and inventories. The higher the ratio, the better the company's liquidity position:

Current聽Ratio=Current聽AssetsCurrent聽Liabilities\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}Current聽Ratio=Current聽LiabilitiesCurrent聽Assets

The Quick Ratio

The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets聽and therefore excludes inventories from its current assets. It is also known as the "acid-test ratio":

Quick聽ratio=C+MS+ARCLwhere:C=cash聽&聽cash聽equivalentsMS=marketable聽securitiesAR=accounts聽receivableCL=current聽liabilities\begin{aligned} &\text{Quick ratio} = \frac{C + MS + AR}{CL} \\ &\textbf{where:}\\ &C=\text{cash \& cash equivalents}\\ &MS=\text{marketable securities}\\ &AR=\text{accounts receivable}\\ &CL=\text{current liabilities}\\ \end{aligned}Quick聽ratio=CLC+MS+ARwhere:C=cash聽&聽cash聽equivalentsMS=marketable聽securitiesAR=accounts聽receivableCL=current聽liabilities

Another way to express this is:

Quick聽ratio=(Current聽assets聽-聽inventory聽-聽prepaid聽expenses)Current聽liabilities\text{Quick ratio} = \frac{(\text{Current assets - inventory - prepaid expenses})}{\text{Current liabilities}}Quick聽ratio=Current聽liabilities(Current聽assets聽-聽inventory聽-聽prepaid聽expenses)

Days Sales Outstanding (DSO)

DSO聽refers to the average number of days it takes a company to collect payment after it makes a sale. A higher DSO means that a company is taking unduly long to collect payment and is tying up capital in receivables. DSOs are generally calculated quarterly or annually:

DSO=Average聽accounts聽receivableRevenue聽per聽day\text{DSO} = \frac{\text{Average accounts receivable}}{\text{Revenue per day}}DSO=Revenue聽per聽dayAverage聽accounts聽receivable

Liquidity Crisis

A聽liquidity crisis聽can arise even at healthy companies if circumstances arise that make it difficult for them to meet short-term obligations such as repaying their loans and paying their employees. The best example of such a far-reaching liquidity catastrophe in recent memory is the global credit crunch of 2007-09. Commercial paper鈥攕hort-term debt that is issued by large companies to finance current assets and pay off current liabilities鈥攑layed a central role in this financial crisis.

A near-total freeze in the $2 trillion U.S. commercial paper market made it exceedingly difficult for even the most solvent companies to raise short-term funds at that time and hastened the demise of giant corporations such as Lehman Brothers and General Motors Company (GM).

But unless the financial system is in a credit crunch, a company-specific liquidity crisis can be resolved relatively easily with a liquidity injection, as long as the company is solvent. This is because the company can pledge some assets if required to raise cash to tide over the liquidity squeeze. This route may not be available for a company that is technically insolvent since a liquidity crisis would exacerbate its financial situation and force it into bankruptcy.

The Difference Between Solvency Ratios and Liquidity Ratios

In contrast to liquidity ratios,聽solvency聽ratios measure a company's ability to meet its total financial obligations. Solvency relates to a company's overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current financial accounts. A company must have more total assets than total liabilities to be solvent and more current assets than current liabilities to be聽liquid. Although solvency does not relate directly to liquidity, liquidity ratios present a preliminary expectation regarding a company's solvency.

The solvency ratio is calculated by dividing a company's聽net income聽and聽depreciation聽by its short-term and聽long-term liabilities. This indicates whether a company's net income is able to cover its聽total liabilities. Generally, a company with a higher solvency ratio is considered to be a more favorable investment.

Examples of Liquidity Ratios

Let's use a couple of these liquidity ratios to demonstrate their effectiveness in assessing a company's financial condition.

Consider two hypothetical companies鈥擫iquids Inc. and Solvents Co.鈥攚ith the following assets and liabilities on their balance sheets (figures in millions of dollars).聽We assume that both companies operate in the same manufacturing sector (i.e., industrial glues and solvents).

Balance Sheet (in millions of dollars) Liquids Inc. Solvents Co.
Cash $5 $1
Marketable Securities $5 $2
Accounts Receivable $10 $2
Inventories $10 $5
Current Assets (a) $30 $10
Plant and Equipment (b) $25 $65
Intangible Assets (c) $20 $0
Total Assets (a + b + c) $75 $75
Current Liabilities* (d) $10 $25
Long-Term Debt (e) $50 $10
Total Liabilities (d + e) $60 $35
Shareholders' Equity $15 $40

*In our example, we will assume that current liabilities only consist of聽accounts payable聽and other liabilities, with no short-term debt.

Liquids Inc.

  • Current ratio=$30 / $10 = 3.0
  • Quick ratio = ($30 鈥 $10) / $10 = 2.0
  • Debt to equity = $50 / $15 = 3.33
  • Debt to assets = $50 / $75 = 0.67

Solvents Co.

  • Current ratio=$10 / $25 = 0.40
  • Quick ratio = ($10 鈥 $5) / $25 = 0.20
  • Debt to equity = $10 / $40 = 0.25
  • Debt to assets = $10 / $75 = 0.13

We can draw a number of conclusions about the financial condition of these two companies from these ratios.

Liquids Inc. has a high degree of liquidity. Based on its current ratio, it has $3 of current assets for every dollar of current liabilities. Its quick ratio points to adequate liquidity even after excluding inventories, with $2 in assets that can be converted rapidly to cash for every dollar of current liabilities.

However, financial leverage based on its solvency ratios appears quite high. Debt exceeds equity by more than three times, while two-thirds of assets have been financed by debt. Note as well that close to half of non-current assets consist of聽intangible assets (such as goodwill and patents). As a result, the ratio of debt to tangible assets鈥攃alculated as ($50/$55)鈥攊s 0.91, which means that over 90% of tangible assets (plant, equipment, and inventories, etc.) have been financed by borrowing. To summarize, Liquids Inc. has a comfortable liquidity position, but it has a dangerously high degree of leverage.

Solvents Co. is in a different position. The company's current ratio of 0.4 indicates an聽inadequate degree of liquidity聽with only 40 cents of current assets available to cover every $1 of current liabilities. The quick ratio suggests an even more dire liquidity position, with only 20 cents of liquid assets for every $1 of current liabilities.

Financial leverage, however, appears to be at comfortable levels, with debt at only 25% of equity and only 13% of assets financed by debt. Even better, the company's asset base consists wholly of tangible assets, which means that Solvents Co.'s ratio of debt to tangible assets is about one-seventh that of Liquids Inc. (approximately 13% vs. 91%). Overall, Solvents Co. is in a dangerous liquidity situation, but it has a comfortable debt position.