How to calculate the 3 most common liquidity ratios
In the second in our series on financial ratios and KPIs, this week we’re looking at liquidity!
There’s nothing to get the juices flowing like liquidity ratio analysis, so let’s dive in!
This week, we’re going to answer 3 questions…
- What is a liquidity ratio in accounting?
- What are the 3 most important liquidity ratios?
- How can small businesses use liquidity in their forecasts?
What is a liquidity ratio in accounting?
Liquidity ratios are often described as showing “a company’s readiness to pay short term debt obligations”.
If that doesn’t help much, don’t worry! In this guide I’ll explain everything!
The thing that always confused me about liquidity ratios is the way that they are expressed. Not coming from a financial background, I had no formal training to tell me how to interpret ratios.
In case you don’t know, liquidity ratios look like this:
Or sometimes, just “2”.
These are just numbers. What do they mean? To the untrained eye, they are meaningless! You really do need to have some context to understand liquidity ratios.
What these numbers show is the ratio of one thing to another. There are many types of liquidity ratio, one of the most common being ‘Current Ratio’ which compares current assets to current liabilities. A ratio of 2:1 means the company has current assets of twice the value of their current liabilities.
The aim of a liquidity ratio is, as the quote above said, to describe how able a company is to pay its debts.
If a company has a lot of debt and those debts are all called in, the business will need to settle these debts. If not, it could potentially face bankruptcy. Liquidity ratios are a test of this situation – does the business have enough current assets to cover the debts it owes – its current liabilities.
So what are current assets and current liabilities?
Both of these terms can be found on the Balance Sheet report. The Balance Sheet is one of the three major financial reports, along with the Cash Flow and Profit and Loss. Each of these cast the business’ activities in a different light. The Balance Sheet focuses on what the business owns, or is due (assets) and what it owes (liabilities).
What are Current Assets?
Assets are things the business owns or is owed. As a general rule, “current” assets are assets that could be converted into cash within a year.
Let’s break down what these could be:
- Receivables – money owed to you that you expect to receive within 12 months.
- Inventory – this can include component parts, goods waiting to be sold, or the materials required to create them.
- Marketable securities – short term investments, etc.
- Cash or cash equivalents
Current assets generally do not include long term investments, fixtures, fittings, plant & equipment or land. These “fixed” or “noncurrent” assets are deemed too inflexible to be easily converted into cash.
What are Current Liabilities?
Liabilities are things that the business owes, something it is liable to pay. A “current” liability is, you guessed it, something the business is liable to pay within 12 months.
Current liabilities include:
- Outstanding loan balances due within 12 months (the repayments you would have to make on a loan)
- Payables – cash that you owe for goods or services, for example unpaid bills.
- Other Liabilities – in some cases you may have been paid in advance for goods or services that you have not yet delivered. This prepayment liability isn’t cash-based, but is still something that your business has agreed to deliver.
So, what is Liquidity?
Liquidity all about cash. At a basic level, many assets are “things” that cannot easily be exchanged for cash in an emergency, at least not without seriously disrupting parts of the business (I could sell this computer, but I wouldn’t get much work done!).
Assets that can be easily liquidated are ones that can be easily transformed into cash. Inventory, products, cash and cash-like money holding mechanisms (short term investments that can be sold at the click of a button) are all deemed to be “liquid” assets.
How much “liquidity” a business has is a way of asking “how much cash can the business raise quickly if it needs to?”
This makes liquidity an important measure of the financial health of a business. Investors, lenders, and potential buyers of the business all need to understand the business’ capability to pay its debts. If the business is in danger of not being able to do so, this doesn’t just speak to problems in the way the business is being managed today, but also in its long term viability. If a company is struggling to pay its short term debts, it may struggle in the long term as well.
Having said this, liquidity ratios aren’t the last word in a business’ health. They are one of many indicators which show how well businesses can survive and flourish.
What liquidity ratios test is a specific scenario.
That scenario is: “what would happen if all of a business’ debts needed to be paid, right now?”
While this situation is unlikely to become a reality for most businesses, it is possible.
Some very large businesses, including major corporations, often fail the liquidity ratio test. Having vast amounts of debt compared to their liquid assets is part of the way their businesses have grown to such heights. But for small businesses, the dangers of bad liquidity ratios can be far more real than for the Disneys and Costcos of the world.
The 3 most important liquidity ratios
The other thing that confused me initially about these ratios is that there seem to be so many of them! The main 3 are:
- Current ratio
- Quick or ‘Acid Test’ ratio
- Operating Cash Flow ratio
So, what’s the difference?
It’s simpler than it seems. It’s to do with what is counted as a ‘liquid asset’ in each ratio. Some ratios assume that any old current asset can be used to settle a debt, while others remove certain types of asset from this side of the equation. These ratios tend to be stricter, as they allow fewer types of asset to cover the debt in each case.
Current Assets / Current Liabilities
We’ve touched on this already. Quick recap. Current ratio, called so because it compares current assets to current liabilities. If you have a balance sheet forecast to work from this is the easiest ratio to calculate – just takes your current assets line and divide it by current liabilities.
Current Ratio is a simple guide of how much cash a business could generate to cover its debts. However, some assets cannot be easily liquidated, which leads on to…
Quick/Acid Test Ratio
(Current Assets – Inventory) / Current Liabilities
The Quick ratio. So called, not because it is quick to calculate, but because it shows how much of a company’s current assets are available quickly. Unlike Current ratio, Quick ratio removes inventory assets from the current assets side of the equation. This ratio deems inventory less ‘liquid’ than cash or receivables.
Operating Cash Flow Ratio
Cash Flow from Operating Activities / Current Liabilities
Unlike Current ratio, Operating cash flow ratio assumes that short term obligations will be paid entirely with cash generated from the business’ operating activities instead of being covered by the business’ current assets.
Generally, cash from operating activities is:
Cash received from sales minus cash paid on goods and services, salaries and interest payments.
This is seen as a simple, and effective way to measure a business’ available cash for settling debts, as cash figures are harder to manipulate than profit-based ones.
How can small businesses use liquidity in their forecasts?
Because liquidity ratios warn us about the future capacity of a business to cope with debt, they have a natural place in financial forecasting.
By working out liquidity ratios for each month of your forecast, you can start to gain an understanding of the future trends in liquidity that your forecast suggests are in store for your business.
A worsening ratio,for example, where the gap between a low cash/current asset side of the ratio and a high current liabilities side is getting larger can be a cause for concern, or at the very least, attention.
Comparing the three ratios presented can help build a liquidity profile for a company. If each ratio presents a similar result, it adds credence to the business’ ability to handle its debt.
Financial forecasts created in tools like Brixx produce cash flow and balance sheet reports. These will provide you will all of the information you need to create the 3 ratios we have discussed above.
As for the forecast itself, this is our speciality! We have a lot of guides available to help you bring together a financial picture of your business: