Liquidity ratios help in understanding the ability of an organisation to meet its short term payment obligations. Understanding a company’s ability to meet its short-term obligations is important to understand its short term financial position.
In this blog, we will understand in detail what is a liquidity ratio and also delve into its types. We will also learn the liquidity ratio formulas to calculate each such ratio and go through examples of how to calculate.
Understanding liquidity ratios
Let us start by understanding what is liquidity ratio.
A liquidity ratio assesses a company’s capacity to pay off its short-term liabilities with its available assets. This financial metric is the litmus test for a company’s short-term financial health.
It ensures that an organisation can meet immediate financial obligations without resorting to external financial support.
But why does this matter?
A healthy liquidity ratio signifies an organisation’s ability to sustain operations. It also tells us about its independence and resilience in facing unexpected financial challenges.
Types of liquidity ratios
Now, let us look at the various types of liquidity ratios and understand their calculation in detail using liquidity ratio examples:
- Current ratio
The current ratio measures the ability of an organisation to pay off its current liabilities using its current assets.
Formula: Current Assets / Current Liabilities
- Current Assets: This is every asset the organisation owns that can be turned into cash within a year, like money in the bank or inventory.
- Current Liabilities: These are all the payments the company needs to make within a year, like bills payables or short term loans.
2:1 is considered to be the ideal current ratio, although it also depends from industry to industry. A current ratio lower than 1 implies an organisation is not in a position to meet its short-term obligations using its current assets.
Example: Imagine a firm with Rs 5,00,000 in current assets and Rs2,50,000 in current liabilities. Its current ratio would be 2 (5,00,000/2,50,000)
It means that it has double the assets needed to cover its liabilities. This is a comfortable liquidity position.
- Quick ratio (Acid-test ratio)
The quick ratio goes a step beyond the current ratio by measuring the ability of a company to meet its current liabilities using its most liquid assets. Inventory and prepaid expenses are deducted from current assets.
Formula: (Current Assets – Inventory- Prepaid Expenses) / Current Liabilities.
- Inventory: Goods a company plans to sell. We subtract this because it might not turn into cash quickly.
- Prepaid Expense: An expense that you have paid in advance like insurance, etc.
An acid-test ratio of 1:1 is generally deemed ideal. A ratio less than 1 signifies insufficient quick assets to meet short-term liabilities.
Example: A fashion retailer, facing rapidly changing trends, has Rs 4,00,000 in current assets, Rs 1,50,000 in inventory, and Rs 2,00,000 in current liabilities.
Quick ratio= 4,00,000-1,50,000/2,00,000= 1.25
Its quick ratio of 1.25 indicates it can easily cover its current liabilities using its quick assets.
- Cash ratio
This ratio is more stringent than the acid test ratio and uses only an organisation’s most liquid assets i.e. cash and marketable securities to measure its ability to pay off short term liabilities.
Formula: Cash and Cash Equivalents / Current Liabilities.
- Cash and cash equivalents: Cash refers to the physical currency (Indian Rupees, in notes and coins) that a company has in its possession or in bank accounts that can be withdrawn on demand.
Cash Equivalents are short-term investments that a company can convert into a known amount of cash, typically within three months or less, without a significant risk of change in value. Eg. Treasury bills, money market funds, etc.
Example: A manufacturing company with Rs 100,000 in cash and equivalents and Rs 200,000 in liabilities will have a cash ratio of
Cash ratio= 1,00,000/2,00,000=0.5
A cash ratio of 0.5 implies that it will struggle to meet obligations with cash alone.
- Absolute liquid ratio
This ratio further sharpens the liquidity focus. It considers only the most liquid assets. Absolute liquid ratio points out a company’s ability to cover liabilities almost immediately.
Absolute liquid ratio Formula: (Cash + Marketable Securities) / Current Liabilities.
- Marketable Securities: These are investments that can be quickly sold in the market with minimal loss of value. Eg. G-Secs, corporate bonds, etc.
Example: An IT firm with Rs 2,00,000 in cash, Rs 50,000 in marketable securities, and Rs 1,50,000 in liabilities. The absolute liquid ratio is:
2,00,000 + 50,000/1,50,000= 1.67
This ratio of 1.67 is a strong indicator of liquid financial health.
- Basic defence ratio
The basic defence ratio determines how long a company can run on its cash expenses without seeking external assistance. It is also called the basic defence interval.
Formula: Cash and Cash Equivalents / Daily Operational Expenditure.
Example: A startup with Marketable Securities ₹50,000, Cash and Equivalent ₹100,000, Receivables ₹150,000, Annual Operational Costs ₹1,095,000, Non-cash Expenses ₹95,000.
Current Assets = ₹50,000 + ₹100,000 + ₹150,000 = ₹300,000
Daily Operational Expenses = (₹1,095,000 – ₹95,000) / 365 = ₹1,000,000 / 365 ≈ ₹2,740 per day
Basic Defense Ratio = Current Assets / Daily Operational Expenses = ₹300,000 / ₹2,740 ≈ 109.5 days
- Basic liquidity ratio
The basic liquidity ratio relates to individuals and is not related to an organisation’s financial position. It measures how much time an individual or a family can finance its needs with its liquid assets. The rule of thumb is to have enough to cover at least three months of expenses.
Formula: Monetary Assets / Monthly Expenditure.
Example: Let’s say Rahul has ₹1,20,000 in his savings account, and his monthly expenses, including rent, utilities, groceries, and other bills, come to ₹40,000.
Basic Liquidity Ratio = ₹1,20,000 / ₹40,000 = 3
This means Rahul has a liquidity ratio of 3, indicating he can financially support himself for three months without any income.
- Liquidity coverage ratio and Statutory liquidity ratio: A special mention
- The liquidity coverage ratio is specifically important for banks. This ratio measures the ability to withstand a 30-day financial stress scenario using high-quality liquid assets. Now let us look at the liquidity coverage ratio formula.
Formula: High-Quality Liquid Assets / Total Net Cash Flows Over 30 Days
- Statutory liquidity ratio is also applicable to banks and is mandated by the Reserve Bank of India. It mandates commercial banks to maintain a certain percentage of their net demand and time liabilities (NDTL) in the form of liquid assets like cash, gold, and government securities.
Formula: (Liquid Assets/Net Demand and Time Liabilities (NDTL))×100
Conclusion
Liquidity ratios are important to understanding a company’s financial health. They give key insights into its ability to meet short-term obligations. Each ratio offers a different view of a company’s liquidity. However, it is important to interpret these ratios in context and complement them with other financial analyses for a holistic view of an organisation’s financial health. To learn more, subscribe to StockGro.
FAQs
The best liquidity ratio will depend on the context and the industry but the most commonly used liquidity ratios are the current ratio and quick ratio.
There are various liquidity ratios, each with its own formula. The most commonly used is the current ratio. Its formula is: Current Assets / Current Liabilities
The formula for the liquidity test ratio is:
(Current Assets – Prepaid Expenses- Inventory) / Current Liabilities
The four common types of ratios are liquidity ratios, solvency ratios, profitability ratios, and activity ratios.
A current ratio of less than 1 might signify the inability of the business to meet its current liabilities using current assets and can be considered a troublesome situation.
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