To stay viable, business requires capital. Even if your company has excellent sales, it will struggle to succeed if it lacks the capital to run. However, examining your company’s cash status entails more than just looking at your bank account.
A liquidity ratio is a financial measure used to assess a company’s capacity to meet its short-term loan commitments. The measure is used to determine if a company’s current assets, or liquid assets, can cover its current liabilities. Typically, businesses use current assets to pay their financial responsibilities. It refers to how rapidly a company can convert its assets into cash in order to meet its short-term financial obligations. Your liquidity ratio indicates if you have the financial resources to meet your forthcoming commitments. Strong liquidity will enable your business to overcome financial obstacles, obtain loans, and plan for the future.
Because cash and stocks are easy to access and exchange, they have a high level of liquidity. Land and real estate are often less liquid and selling and obtaining money from them take a significant time.
Three liquidity ratios are being used most commonly:
This ratio, also known as the capital ratio, demonstrates your ability to pay short-term debts due within a year from current assets such as cash, receivables, and short-term loans. A higher ratio suggests that the company is better equipped to repay its short-term loans. These ratios will vary by industry, but in general, 1.5 to 2.5 represents satisfactory liquidity and efficient working capital management.
Current ratio = current assets / current liabilities
This suggests that the business has $1.50 in current liabilities for every $1 in current assets. Lower ratios may suggest liquidity issues, whilst higher ratios may indicate that there is too much working capital occupied in inventories.
The quick ratio is, also known as the Acid test ratio, assesses your ability to pay off existing debts using assets that can be converted into cash in less than 90 days. Both are similar in that the numerator is current assets and the denominator is current liabilities. The quick ratio is more stringent than the current ratio when it comes to determining liquidity.
Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities
This ratio is more conservative since it excludes the current asset that is the most difficult to convert to cash. Divide the current liquid assets by the current liabilities to get at this ratio.
The cash ratio is a measure of a company’s liquidity that determines if it has the ability to pay down obligations entirely with liquid assets (cash and cash equivalents to total liabilities). Creditors and distributors use this ratio to evaluate your ability to pay back debts, in addition to giving you an indicator of your company’s financial health. A healthy cash flow ratio is at least.5. This demonstrates the company’s ability to pay back short-term debt with its most liquid assets, cash and cash equivalents.
Cash ratio = Cash and equivalent / Current liabilities
Because the numerator of the equations differs between the three ratios, an appropriate ratio will vary between them. It stands to reason because the numerator of the cash ratio only includes cash and liquid assets, whereas the numerator of the current ratio consists of all current assets.
Financial ratios are a quick way to evaluate your company’s liquidity and sustainability using a variety of situations, such as paying liabilities with cash and cash equivalents, accounts receivable, and even disposing, or liquidating, some of your machinery and equipment. These ratios can also be used to compare your company to others in your sector and to develop targets for maintaining or achieving financial objectives.
Liquidity ratios are used to assist people to comprehend a company’s financial situation. It also aids in determining the firm’s short-term financial status. A larger ratio indicates that the company is stable, whilst a low ratio indicates that the company is at risk of financial loss.
It’s vital to know the ratios in detail. Are you making the best use of your resources if you have a ratio that suggests you can easily cover your liabilities? You might want to cut costs, enhance credit control to transform receivables into cash or take out a loan to get more money. Furthermore, if the reason for the greater ratio is rising inventory levels or receivables, it could suggest slow-moving inventory or inadequate credit control. Both of these factors could point to future incidents. You must act swiftly to minimise risk if your ratios are below a safe range.
The ratio provides a thorough picture of the company’s operating system. It shows how well the company sells its products and services in order to turn inventories into cash. This ratio can assist the business in improving its production process and planning better inventory storage to reduce losses and manage overhead costs.
When assessing organisations’ finances in different sectors or when there is a significant difference in the size of the companies being evaluated, comparing liquidity ratios is less helpful because they may require distinct financing structures. It’s also important to use liquidity ratios in the context of other indicators and company dynamics to get a more accurate view of a company’s financial health.
Liquidity and solvency are not interchangeable terms; they are two different concepts. Liquidity is a measure that evaluates your company’s capacity to satisfy short-term financial commitments due in less than a year. Solvency is a measure that assesses a company’s capacity to fulfil long-term obligations, including bank loans, pensions, and credit lines. The current, quick, and cash ratios are used to assess liquidity. Other ratios are used to determine solvency.
Businesses require liquidity to pay their expenses. Liquidity ratios are a key indicator of a company’s financial health because they evaluate its ability to meet short-term commitments. They can also be used to compare the financial strength of businesses in the same industry.
When it comes to an SME business, it’s essential to be cautious about putting too much weight on sales growth as a measure of financial health. A company can make some changes to ensure it can cover its debts, optimise the period it holds onto cash, and ensure that if it requires financing from a bank or investor, it is in the best possible position to receive that money by taking other factors into account, such as liquidity.
Understanding your liquidity position is critical, but not every organisation is proficient in this area. Bloom Financials’ team of accountants has extensive experience assisting businesses in preparing and analysing liquidity ratios and business analysis. Contact us to get a detailed analysis.