What is liquidity ratio ?

Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Liquidity ratios are most useful when they are used in comparative form. This analysis may be internal or external. It can be useful to compare your ratios with those of competitors or the industry average to provide a benchmark for analysis. For current ratios, for example, a figure of 1.5:1 is regarded as acceptable.

Assets vs liabilities

The key elements of the liquidity ratio are assets and liabilities. Assets are what you own and use to run your business. They might include property, stock, machinery and equipment, as well as cash, bank deposits, loans, grants, overdrafts and receivables – the amounts your customers owe on invoice. Liabilities are what you owe to banks, suppliers, tax authorities or other creditors.

Some assets like property, machinery and equipment are the least liquid and stock may not sell quickly enough to meet demands so we must take them out of the equation when calculating liquidity ratios.

Common liquidity ratios

Current ratio (working capital ratio)

Indicates your ability to pay short-term liabilities payable within 12 months from current assets such as cash or cash equivalents, trade receivables and short-term deposits.

Current ratio = Current assets / Current liabilities

Example:

If your current assets are £100,000 while your current liabilities are £50,000 your current ratio will be 2:1meaning that you are in good position to cover your debts.

Quick ratio (acid test ratio)

Measures a company's ability to meet its short-term obligations with its most liquid assets and therefore excludes inventories from its current assets.

Quick ratio=Current assets - inventory - prepaid expenses / Current liabilities

Cash ratio

This ratio is also used by lenders and suppliers to measure your ability to repay your debts.

This is the ratio of cash and cash equivalents to total liabilities.

Cash ratio=Cash + Cash equivalents / current liabilities

Why are the ratios important ?

The ratios provide a useful guide to the current financial health of your business but it’s important to put the ratios in context. If you have a ratio that indicates you can meet your liabilities comfortably, are you making the best use of your assets? For example, if you have a very high ratio of assets to liabilities, you could be making more productive use of the cash to invest in the growth of your business.

Increasing stock levels could indicate that you are not selling your product fast enough or have poor credit control

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