In simple words liquidity means how quickly you can get your hands on cash. In other words, how quickly you can get your money whenever you need it.
For a company, liquidity means how quickly a company’s assets can be converted to cash when it’s bought and sold, or whenever you need cash.
To measure liquidity of a company or organization, certain universal financial ratios are used, known as liquidity ratios.
Liquidity ratios are used to measure a company’s ability to meet its short term obligations. Liquidity ratios tells you how quickly assets of a company can be converted into cash.
In day to day business, a company’s liquidity is managed through efficient use of assets.
How liquidity ratios are calculated?
The current, quick, cash, and defensive interval ratios are four most important liquidity ratios that measure a company’s ability to pay current liabilities.
Here is how these liquidity ratios are calculated;
| Type of liquidity ratios | Formula to calculate various liquidity ratios |
|---|---|
| Current ratio | Current asset / current liabilities |
| Quick ratio | (cash + short term marketable investments + receivables ) / current liabilities |
| Cash ratio | (cash + short term marketable investments) / current liabilities |
| Defensive interval ratio | (cash + short term investments + receivables) / daily cash expenditures |
Interpretation of liquidity ratios
Current ratio expresses current assets in relation to current liabilities. Current assets are those assets which are expected to be consumed or converted into cash within a year. Current liabilities are company’s short term obligations that are falling due within a year.
High current ratio indicates higher level of liquidity, as it shows greater ability to meet company’s short term obligations.
A standard current ratio of 1 indicates that the book value of a company’s current assets exactly equals the book value of its current liabilities. Therefore, anything higher than 1 suggests higher liquidity. A comparison with current ratios of immediate competitors within the same industry is a better way to know the liquidity position of a company.
A low current ratio indicates a greater reliance on operating cash flow or outside finance.
Quick ratio is a more conservative way of calculating a company’s liquidity position. Instead of taking all the current assets in the numerator, you take only those current assets which are more liquid such as cash and cash equivalents.
In cash ratio calculation, you take only cash and highly marketable short term investments to compare with current liabilities.
Interpretation of quick and cash ratio is similar to current ratio. A higher quick and cash ratio indicates greater liquidity.
Defensive interval ratio is a measure to know how long the company can continue to pay its day to day expenses from its existing liquid assets without receiving any additional cash inflow to business.
A defensive interval ratio of 10 indicates that the company can pay its operating expenses for 10 days before running out of money assuming no additional cash inflows to business.
In addition to these liquidity ratios analysts also use the cash conversion cycle of a company to know the net operating cycle.
Cash conversion cycle is calculated by adding Days of inventory on hand (DOH), Days of sales outstanding (DSO) minus number of days of payable. This metric tells you the amount of time that the company takes to get back cash from the point of investment in working capital until the point at which the company collects cash.
The time between the outlay of cash and the collection of cash is called the cash conversion cycle. Shorter cash conversion cycle indicates greater liquidity as the company needs a short period of time to finance its inventory and accounts receivables.
Is high liquidity good?
The level of liquidity differs from one industry to another. Therefore, you should compare liquidity levels with another company of the same industry.
In general, larger companies are in a better position in managing its liquidity level, than smaller companies as they have more potential sources of funding.
What is solvency vs liquidity?
Solvency refers to a company’s ability to meet its long term obligations.
Liquidity refers to a company’s ability to meet its short term obligations.
In order to assess a company’s financial health, analysts calculate both solvency and liquidity ratios based on the data available in the financial statements.
