What is a liquidity ratio?
A liquidity ratio is a measurement that shows how much cash an organization has available to pay bills and debts. Companies use several liquidity ratio formulas to evaluate their various assets and liabilities. In most cases, liquidity ratios demonstrate a business’ ability to pay off short-term debts or obligations but can’t predict what may happen in the long term. In most cases, the higher the liquidity ratio, the more likely the company has enough liquid assets to meet its financial needs, while low liquidity ratios might concern potential investors.
Liquidity ratios are a valuable tool for investors, but creditors use them as well. When a company needs access to capital, banks review liquidity ratios to assess risk and determine creditworthiness. A low liquidity ratio may be a sign that a business is entering rough financial waters in the near future. Banks may charge higher interest rates or decline loans if they’re not satisfied with a company’s liquidity ratio.
Chief Financial Officers (CFOs) and financial managers are responsible for monitoring a company’s financial health and may use a liquidity ratio to determine whether the business needs to shift course. They can use a liquidity ratio formula to determine if it’s time to expand, pursue new investments or begin making cutbacks.
Related: How to Hire a Chief Financial Officer
Why you should use liquidity ratios
Liquidity ratios help executives understand a company’s financial situation more deeply than reviewing balance sheets and revenue reports. It reveals how much cash is available and how quickly the business can come up with cash on demand while providing in-depth information regarding a company’s debts and liabilities. Your CFO may use these formulas to decide whether to implement different financial strategies to improve your company’s financial standing.
Comparative analysis can help reveal whether cost-saving measures or strategies for increasing revenue have been successful by comparing ratios over extended periods. Knowing whether your current strategies are effective lets you make tweaks to improve or consider different investment ideas to ensure you’re able to pay your bills and debt while scaling operations.
Liquidity ratios can also be used to determine how effective your CFO has been discharging their duties. While it’s an important tool for evaluating your company’s financial health, it’s also used for internal evaluations, such as progress reports and employee reviews. If your CFO has been with your company for a while now and your liquidity ratio isn’t improving, it may be reflective of their performance and signal the need for a change.
Related: 5 CFO Chief Financial Officer Interview Questions and Answers
Types of liquidity ratios
Businesses use several liquidity ratios to establish a clear understanding of their financial position. Here is the definition of liquidity ratios and how to calculate liquidity ratio for your business :
Current ratio
The current ratio provides a measurement of a business’ ability to pay current expenses and liabilities with the cash and liquid assets they have on hand. Most current ratios define “current” to mean “within the year,” which means it includes assets that can be converted into cash within the next 12 months. The formula for current ratio is:
Current assets / current liabilities = current ratio
Current assets don’t include any types of investment or capital that you’re unable to convert into cash inside the next year. The formula only determines whether your business can liquify assets to pay off debt or meet its short-term financial obligations.
Quick ratio
The quick ratio, or acid-test ratio, measures whether a company can pay its short-term expenses by using its most liquid assets. This calculation does not include inventories as an asset. To calculate the quick ratio, use this formula:
(Current assets – inventory – prepaid expenses) / current liabilities = quick ratio
Some liquidity measurement ratios include inventory as a liquid asset due to the assumption that sales generate cash. Using the quick ratio lets you know if you can still pay your bills during a lull in sales and how your business may be affected if you encounter an economic downturn.
Related: Inventory Management: An Intro for Small Business Owners
Day Sales Outstanding (DSO) ratio
This liquidity ratio calculation measures the length of time it takes a company to collect payment from a customer following a sale. A long delay in receiving payment might negatively impact the company’s ability to manage its debts and expenses. Use this formula to measure your DSO ratio:
Average accounts receivable / revenue per day = DSO ratio
If you’ve noticed a significant delay in receiving payments following sales, you may want to consider what’s causing the delay and if you’re maintaining enough cash on hand to continue paying your bills until new revenue turns liquid.
Cash ratio
The cash ratio measures company’s cash and cash equivalent assets compared to all the company’s liabilities. Creditors normally use this ratio so they can see how likely a company is to pay its short-term debts. To find your cash ratio, use this formula:
Cash + cash equivalents / current liabilities = cash ratio
This liquidity ratio formula offers the simplest determination of a company’s health in the eyes of creditors. Having a lot of cash on hand to meet your liabilities can make it much easier to obtain working capital through loans and investments because your company shows a strong ability to avoid common financial pitfalls.
Working capital ratio
The working capital ratio helps companies see how much additional capital they have for investing or business development after they pay all their bills. It’s an important assessment to make if you’re considering scaling your operations or expanding into new markets. Use this formula to find your working capital ratio:
Current assets – current liabilities = working capital ratio
While lenders lean more toward the cash ratio to determine whether to offer you money, you may wish to use your working capital ratio to consider the viability of seeking new loans. It lets you know if you’re able to cover additional interest payments on your debt before you seek additional funding.
Frequently asked questions about liquidity ratios
What is the liquidity ratio investors use before deciding whether to buy stock?
Potential investors may use more than one liquidity measurement formula to decide whether a company is healthy enough to invest in. Liquidity ratios are only one of many formulas that investors use to review business finances before making important investment decisions.
What is a good liquidity ratio to maintain?
A liquidity ratio under 1 is concerning, especially to lenders more likely to offer loans to companies that maintain ratios above 2. If your business has a liquidity ratio under 1, you might have trouble paying your bills in the near future and need to reassess your financial strategy.
Can liquidity ratios be too high?
Having too much cash available is concerning to lenders and investors as well. It means that you’re not using your assets efficiently and may be passing on growth opportunities. If you have a lot of cash available and aren’t using it to scale, your competitors may gain an edge if they’re using their capital efficiently.
