Liquidity ratios are used to determine a company’s ability to pay off its short-terms debts. Short term means 12 months and less.
Liquidity ratios can be of enormous benefit to business owners, Directors and Managers when developing budgets. They tend also to be of great interest to lenders, Creditors, potential investors and prospective Managers and Directors when making decisions as to whether or not to join a company.
Common liquidity ratios include the Working Capital Ratio, the Current Ratio, the Quick Ratio and the Operating Cash Flow Ratio.
The Working Capital Ratio measures how much Working Capital is needed to finance every dollar of Sales:
Working Capital Ratio = (Debtors + Inventories – Creditors) / Annual Revenue
A Working Capital Ratio of 0.3 means that the business needs 30 cents of Working Capital for every dollar of Revenue. In other words, for each $1,000,000 increase in Revenue, the business needs to fund $300,000 of Working Capital. You can see from this simple example how important it is to know this ratio when doing your budget and/or determining the funding you might need in order to support an increase in Revenue.
The Current Ratio measures the ability of a company to pay its debts over the next 12 months:
Current Ratio = Current Assets / Current Liabilities
While not an absolute certainty, a ratio below 1 indicates that the business may have problems meeting its short term obligations.
It’s important to note that not all Current Assets have the same level of liquidity. Cash is available immediately, Creditors should convert into Cash rather quickly, but Inventories may take several months to become Cash. So lenders and banks prefer to use the Quick Ratio, as they know that inventories may not be able to cover short-term debts in a case of emergency.
The Quick Ratio, also called Acid Test Ratio, measures the ability of a company to use its near cash assets to pay its almost immediate debts:
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
The Quick Ratio takes only the most liquid current assets (Cash, Marketable Securities and Debtors) and compares them with the current liabilities. A ratio below 1 indicates that the business will not likely be able to pay back its current liabilities at short notice.
Generally, the higher the value of the Current Ratio and Quick Ratio, the larger the margin of safety the company has to cover short-term debts.
The final key Liquidity Ratio to consider is the Operating Cash Flow Ratio:
Operating Cash Flow Ratio = Cash Flow Income from Operations / Current Liabilities
This ratio measures how many times in a year the cash generated by the business can pay its short term debts. This ratio needs to be above 1 and the higher, the better. Should this ratio fall below 1, it means one year of cash flow cannot pay the debts due within the year, and that’s a strong alarm bell!