Liquidity Ratio: The Water of Accounting Ratios

Are you a shopping enthusiast? Do you love buying new things? There would hardly be any person who does not like buying fresh, new stuff. The one common pattern found with almost every shopper is the process of a proper analysis of the product before actually buying it.

A prudent buyer, after looking at the various aspects of a product; the material used, defectiveness, customer satisfaction percentage, refund rate, etc., arrives at the decision of whether the product is actually worth the price stated.

Similarly, finance enthusiasts and market investors use their buying and analytical skills on the stock market. An investor inclined to buy a company's stocks should analyze and explore that company's financial statements with great seriousness and caution.

While exploring the financial statements of any company, the first thing you should look at is the liquidity ratios. They are essential to analyze and measure the liquidity position of the company.

While the term 'liquidity ratios' must be known to most financial geeks, it might be a fairly new term for their nonfinancial peers.

Let's dive in to take a better look at liquidity ratios.

What is the Liquidity ratio?

Liquidity ratio is one of the most important factors to be kept in mind before investing in a company. It is a crucial accounting instrument used to infer a borrower's current debt repaying capacity or proficiency.

In simple words, it could be defined as the Ratio that indicates whether an individual or business can pay off the short-term dues without any outer financial assistance. Considering the liquid assets of the respective company, its present financial duties of it are analyzed to substantiate the safety limit of a company.

What are the 3 types of Liquidity Ratios?

Liquidity Ratios are categorized into two categories: Current Ratio and Quick Ratio or Liquid Ratio or Acid Test Ratio. Both the ratios are very crucial and important in accounting as well as in the trading world, as the investors do consider these ratios critically. Let's understand these ratios one by one.

1. Current Ratio

The Current Ratio is a liquidity ratio that measures the ability of the enterprise to pay its short-term financial obligations, i.e., current liabilities. It is a relationship of current assets and current liabilities.

This ratio indicates whether the company will be able to pay its short-term financial obligations when they become due for payment. Thus, the Current Ratio is the measurement of the short-term financial health of the enterprise.

Current Ratio = Current Assets/Current Liabilities 

Here, the current assets include cash, stock, receivables, prepaid expenditures, marketable securities, deposits, etc. And current liabilities include short-term loans, payroll liabilities, outstanding expenses, creditors, various other payables, etc. The current ratio is expressed as a pure ratio. The idle current Ratio is 2:1. 

Example of Current Ratio

There is a company 'X' which is in the business of furniture. According to the balance sheet of the company, the total of its current assets equals to Rs. 60,00,000, and its current liabilities are Rs. 20,00,000. The Current Ratio of the company will be calculated in the following manner:

Current Ratio = Current Assets/Current Liabilities

As seen above, the current Ratio of company X is 3:1, which can be considered satisfactory.

2. Quick Ratio

Quick Ratio is also known as the liquid Ratio or acid test ratio that determines a company's current available liquidity. It is a relationship of a company's liquid assets with its current liabilities. Quick Ratio is expressed as a pure ratio. The idle quick ratio is 1:1. 

Quick ratio = Liquid Assets or Quick Assets/ Current Liabilities

What are liquid assets?

Liquid assets are those assets that can easily be converted into cash in a very short period of time. Liquid assets include assets like cash, money market instruments, and marketable securities.

Liquid Assets = Current assets – Inventories – Prepaid Expenses.

Example of Quick Ratio

Suppose a company 'Y Ltd' is a textile-based company. The current assets of Y Ltd are recorded as Rs. 80,000, current liabilities as Rs. 50,000, inventories as Rs. 25,000, and prepaid expenses as Rs. 5,000. The liquid ratio of Y Ltd will be calculated in the following manner:

Liquid assets = Current assets - Inventories - Prepaid Expenses

Quick ratio = Liquid Assets or Quick Assets/ Current Liabilities               

As seen above, the liquid Ratio of Y Ltd is 1:1, which is an idle ratio. So, it can be said that the company's liquidity position is quite satisfactory.

3. Cash Ratio

The cash ratio or cash asset ratio is a liquidity metric that indicates a company's capacity to pay off short-term debt obligations with its cash and cash equivalents.

Compared to other liquidity ratios such as the Current Ratio and Quick Ratio, the cash ratio is a stricter, more conservative measure because only cash and cash equivalents, a company's most liquid assets, are used in the calculation. A Business should strive for a cash ratio of 0.5 or above.

Cash Ratio = Cash and Cash Equivalents/ Current Liabilities 

Example of Cash Ratio

A company ‘Z Ltd’ balance sheet lists the following items, Cash Rs. 10,000 Cash equivalents Rs. 20,000, Accounts receivable Rs. 5,0000, Inventory Rs. 30,000, Property & equipment Rs. 50,000, Accounts payable Rs. 12,000, Short-term debt Rs. 10,000, Long-term debt Rs. 20,000

Cash Ratio = Cash and Cash Equivalents/ Current Liabilities

Why is the Liquidity Ratio important?

When closely examined, the liquidity ratio's importance could be enumerated in a list. Let's look at how this financial metric helps gain insightful knowledge of a company's financial position.

• The cash richness of a company could be understood via its Liquidity ratio. The liquidity ratio also helps in anticipating the short-term financial position of the company. A higher liquidity ratio indicates stability at the company's end. On the other hand, a poor liquidity ratio holds up the risk of monetary damages for the company.
   
• The liquidity ratio furnishes us with a complete idea of the respected company's operating system. By showing the company's ability to convert the inventories into cash, the liquidity ratio also illustrates how effective as well as efficiently the company sells its product or services to its customers. With the help of the liquidity ratio, a company can plan to improve its production system, plan generous inventory storage to avoid any loss, and also prepare its overhead expenses.
   
• Management plays a crucial role everywhere. Hence, a company's financial stability is somehow also dependent on its management. Therefore, considering the liquidity ratio while evaluating its financial statements, a company can optimize its management efficiency while following the demands of potential creditors of the company.
   
• With the help of the liquidity ratio, the management of the concerned company could also work towards the betterment of the working capital requirements of the company.

What are the limitations of the Liquidity Ratio?

Though several benefits are associated with the liquidity ratio, it is also prone to some limitations. So, what are these limitations, and can they be overseen? Let's find out:

• The most common limitation we frequently encounter in the accounting world is also seen in the liquidity ratio case. Just as liquid assets are crucial, their quality also plays a critical part. The amount of a company's current assets is the only thing that is considered in the liquidity ratio. Hence, it is advisable to contemplate the other accounting metrics along with the liquidity ratio while analyzing a company's liquid strength.
   
• The liquidity ratio also takes into account the inventory to calculate a company's liquidity. However, this could result in miscalculation due to overestimation in some areas. Higher inventory could also be a result of fewer sales. Therefore, inventory calculation might not indicate the real liquidity of the respected company.
   
• The liquidity ratio might also be a consequence of creative accounting, as the balance sheet information is the only thing included in it. To discern a particular company's most accurate financial position, analysts must go beyond the data provided on the balance sheet to perform liquidity ratio analysis. It could help in understanding the company from a different direction.

The Bottom Line

If you plan to try your luck in the stock markets, then the above information could benefit you. The liquidity ratio is one of the most basic financial figures that should be comprehended by any investor.

However, it should not be the only factor to be considered while making an investment decision. Liquidity ratios may be a very small aspect while considering a company's prospects, but it will make a bigger impact in the overall picture. One can't just ignore the fact that if a company is not doing numerically good, then it's not doing wonders otherwise also.

Educating and updating yourself with such basic financial terms can make your experience in the trading and business world more exciting and success-oriented.

Happy (and smart) investing!