3 liquidity ratios: Assessing short-term financial viability
Measuring a company’s liquidity ratio is like checking a car’s fuel or electricity gauge.
Even a zippy Lamborghini or top-of-the-line Tesla won’t get you to your destination if it runs short of juice. Likewise, if a company runs out of cash—or assets to be converted to cash—to pay its short-term liabilities, well, that’s potentially the end of the line for the company, right? Maybe, or maybe not. But it certainly helps to know when a company appears to be running out of gas (liquidity).
As an investor, it helps to know how Wall Street analysts compute and assess three common liquidity ratios—current, quick, and cash—on a regular basis. These ratios can help you:
- Assess how well a company manages its cash.
- Detect a company’s credit risk, particularly if you invest in corporate bonds.
- Optimize your risk and return.
Key Points
- Liquidity ratios are designed to assess a company’s ability to pay its short-term debt obligations.
- The current ratio compares current assets to current liabilities, while the quick ratio strips inventories from the asset base.
- The cash ratio compares cash, cash equivalents, and marketable securities to current liabilities.
What is a liquidity ratio?
Liquidity is the accessibility of capital (money) that’s transaction-ready.
- Cash, for instance, is the most liquid asset you can have. Need to buy something? Pull out your cash and buy it.
- Real estate, on the other hand, is among the least liquid assets you can own. The process of converting a property to cash can be long and complex. Even taking out a home equity loan or second mortgage can be costly and time-consuming. And during that time, the property’s value can fluctuate depending on the state of the market.
A liquidity ratio is a financial metric used to assess a company’s ability to pay off its short-term financial obligations using only its existing assets.
These short-term obligations, also called “current liabilities,” are debt obligations that must be paid within a year (or within a company’s current fiscal year).
If a company has to make regular debt service payments—or even payments to fund daily operations—it’s crucial to have a steady stream of cash and/or or assets that can quickly be converted to cash. Liquidity ratios can help you evaluate a company’s ability to do this.
There are various liquidity ratios used in corporate finance. Each one highlights different angles on a company’s assets and liabilities. You can find this information on a company’s balance sheet—focus on the current assets and current liabilities sections.
1. Current ratio
The current ratio measures a company’s ability to pay off its short-term obligations with its current assets. Current assets include cash, cash equivalents, accounts receivable, marketable securities (financial instruments such as stocks, bonds, T-bills, mutual funds, and certain derivatives, that can be sold quickly on a public market), prepaid liabilities, and inventories. Here’s how to calculate it:
Current ratio = current assets / current liabilities
If the ratio is greater than 1.0, meaning the company has more current assets than liabilities, it indicates that it has the capacity to pay off its short-term obligations. The higher the number, the healthier the company’s financial position.
Example:
- Suppose a small business has current assets of $300,000 and current liabilities of $250,000.
- This means it has a current ratio of (300,000/250,000) = 1.2 (or 1.20 units of assets for each unit of liability).
- The company has enough assets to take care of its short-term financial obligations.
If the ratio were less than 1.0, then its liabilities would outweigh its assets, indicating the company might struggle to pay off its short-term obligations.
2. Quick ratio (acid-test ratio)
The quick ratio goes by two other names: the acid-test ratio and the lesser known liquid capital ratio. The quick ratio is similar to the current ratio, with one big difference: it excludes inventories.
Why does it exclude inventories? This ratio aims to include only a company’s most liquid assets, and inventory takes time to sell, making it less liquid than other assets.
The calculation for the quick ratio goes like this:
Quick ratio = current assets (excluding inventories) / current liabilities
For example:
- Suppose that out of the company’s current assets of $300,000, $100,000 is inventory.
- Subtracting inventories from current assets would reduce the numerator to $200,000.
- Based on the quick ratio formula, the company’s liquidity ratio would be 0.8 (meaning that for every unit of short-term obligations, it can only cover 80%).
What does this mean? In the event of a cash crunch, if the company were unable to quickly sell its inventories, it might not be able to raise enough cash to cover its short-term obligations.
3. Cash ratio
The most stringent and conservative of all liquidity ratios is the cash ratio, which takes into account only a company’s cash, cash equivalents, and marketable securities among its current assets.
Cash ratio = cash or cash equivalents + marketable securities / current liabilities
A company with a high cash ratio has a very strong liquidity position. But some analysts see this as a double-edged sword. Cash is king in a crisis, as the saying goes, but holding too much of it might mean a company isn’t doing enough to put its money to work. Perhaps it would be better off upgrading its fixed assets, seeking a strategic acquisition, or, short of other opportunities, return cash to shareholders via a dividend or stock buyback.
Balance sheet: Household edition
Do you track your net worth? If so, you’re essentially keeping a household balance sheet. Perhaps you should look at your household liquidity ratios as well. Learn more about net worth and your personal balance sheet.
How can I use this to make better investment decisions?
When you’re looking at a company’s liquidity position, it’s important to frame it in the proper context. But that may mean blending art and science—with a bit of subjectivity mixed in. The way you apply these ratios to different company types and industries can make a difference. Here are a few tips.
1. Make comparisons. Perhaps the most basic use of any liquidity ratio would be to compare companies’ ability to pay off their short-term obligations. For instance, if company A has a current ratio of 1.25, while company B’s ratio stands at 0.60, that certainly gives you compelling signs about their financial stability that would prompt you to investigate further. Why is company A holding current assets? Does it expect a big outlay, such as an acquisition (good) or legal settlement (bad)? And what about company B’s low liquidity ratio—should investors be worried about a potential default?
2. Apply liquidity ratios to different company sizes. Early-stage start-ups often have very low liquidity because of high expenses and low revenue. It might make more sense to analyze their growth potential and cash burn rate (a different set of calculations altogether).
For smaller and midsize businesses, particularly for those with limited access to capital markets and other forms of external financing, liquidity ratios are both important and applicable.
Larger businesses will likely have more stable cash flows and access to financing. So, when you see drastic deviations in their liquidity ratios, it’s a hint that you should probably take a closer look.
3. Apply liquidity ratios across different industries. When applying a liquidity ratio to a company, make sure to choose the one that best applies to its sector and industry.
For instance, retail and manufacturing companies often hold significant inventory levels. So you might deem the quick ratio, which excludes inventories, to be more relevant than the current ratio. Service companies, on the other hand, don’t usually hold the same level of inventories, so perhaps the current ratio may be more relevant.
If you’re looking to analyze a bank or financial institution’s liquidity, you can use any of the three. But note that there are other industry-specific ratios, like the liquidity coverage ratio (LCR) or loan-to-deposit ratio (LDR), that the Federal Reserve and other regulators use to determine a financial institution’s ability to weather a crisis.
The bottom line
Liquidity ratios provide insight into one important facet of a company’s financial health. Essentially, they can help you figure out whether the company can pay its bills in the short term. The right ratio can help you weed out companies that are unsuitable for investment.
Still, paying the bills is only one (important) part of a company’s bigger story. So if a ratio does raise a red flag, think of it as a prompt to dig deeper, not as a final assessment of a company’s prospects for future success.
And if you’re holding shares of a company, watch for signs of liquidity deterioration. It could be a sign that this company no longer meets your objectives and risk tolerance.
- Liquidity Ratio | corporatefinanceinstitute.com
- The Liquidity Coverage Ratio and Corporate Liquidity Management | federalreserve.gov