These are an important class of financial metrics and are aimed at determining if a debtor can pay off an existing debt without the necessity of raising external capital. As such, speaking of a company, the Liquidity ratio is used to determine the company’s ability to pay off debts and the margin of safety by involving metrics calculation which includes the current ratio, quick ratio, and operating cash flow ratio.
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Liquidity is the ability of a company to own assets that can be converted into cash; therefore, liquidity ratios can be used to analyze and measure the company’s position by understanding the relationship between the current assets and liabilities of the company.
Liquidity ratio can be divided into the following types:
- Current Ratio: This is defined as the measure of how the company’s current liabilities can be covered by the current assets (including Inventories, Receivable, Cash, and Cash Equivalents). The current ratio is usually the most commonly observable liquidity ratio which is used in assessing or measuring any liquidity. The current ratio is equal to the ratio of current assets to current liabilities. Using the formula, it can be observed that if the current ratio is greater than one, it means the current assets are greater than the liabilities and such a condition is favorable for any company. However, in a situation where the current ratio is less than one, the company might find it difficult to manage the current liabilities with the currently possessed assets.
- Quick Ratio: It is one of the most popular liquidity ratios which is normally used in various assessments. It is a ratio of the company’s most liquid assets (cash and cash equivalents) over the current liabilities. This ratio removes the inventories from the assets based upon the simple assumption that these require more time to be converted into cash. The ratio being greater than one is an indication that the company is currently holding a good position financially as it can manage its liquid liabilities with cash/cash equivalents.
- Cash Ratio: This liquidity ratio accounts for only cash, cash equivalent, and investment fund in the calculation and assessment and is calculated by dividing the current liability by the sum of cash, cash equivalent, and investment fund). It is quite like the Quick ratio and indicates the measure as to how the company’s cash equivalent can repay the liabilities.
- Working Capital Ratio: This ratio also concerns the Current assets and Current Liabilities and is calculated in a similar way as of the current ratio. The main aim of the ratio is to assess whether the company’s current assets are enough to pay off the current liabilities and is considered healthy when the ratio is greater than one.
- Times Interest Earned Ratio: This Liquidity ratio is used to assess whether a company will be able to cover its current interest expenses or interest charge by the company’s profit before interest and tax. A ratio higher than one indicates the ability of the company to pay off the interest charge by its profits, while a ratio of less than one indicates the requirement of the company to look for other alternatives to pay off the interests.
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Importance of Liquidity Ratios
These ratios can be used by the company itself to assess its position and ensure that it is not rated down due to poor liquidity ratio by creditors, bankers, shareholders, and other related stakeholders. It can also be used as a review by the company’s board of directors to assess their performance. Moreover, a company is required to ensure from time to time that the ratio looks good since a company with poor ratios can be actively avoided by the stakeholders for any deep involvement and even the banks, creditors and investors look into these ratios for assessing a company before providing credit terms, a loan or investing in the new fund.
Author: Abhay Kanodia
About the author: An undergraduate student from the Birla Institute of Technology and Sciences, Pilani(BITS Pilani). Exploring the fields of finance and data analytics and its applications in other different domains.