In finance, liquidity typically refers to the ease and speed at which a company can convert assets to cash to meet financial obligations. It also measures a company’s ability to meet financial obligations without having to issue more bonds or shares of common stock. Understanding the liquidity of a company is important because it gives you a good idea of how the company stands from a financial perspective. To do this, you can leverage liquidity ratio formulas.
There are a few different liquidity ratios you should be aware of if you plan to thoroughly analyze a company. These include:
- The current ratio
- The quick ratio
- The cash asset ratio
This article will provide you with a concise explanation of each ratio, as well as its accompanying formula. We will also cover some considerations to keep in mind regarding liquidity ratios.
Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.
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The Current Ratio
In quick terms, the current ratio measures the level of a company’s current assets to its liabilities. It does so with a simple formula: (current assets/current liabilities).
“Current assets” includes a firm’s inventory, cash, accounts receivable, and other items that can convert to cash within a year or less. The “other” category can include anything from manufacturing plants to the equipment within.
On the other hand, “current liabilities” is defined as any debt obligations, wages, taxes due, etc that must be paid within a year or less.
The current ratio can give you a snapshot of how well a firm can handle its debt obligations and operating costs with its current assets. For instance, a ratio of 1.0 or greater indicates that a firm has more assets at hand than liabilities. This is generally a positive sign in terms of financial health.
In the reverse, a ratio of less than one indicates that a firm has more current liabilities than assets on its balance sheet. This could be a sign that the firm is facing some financial distress. Alternatively, the company may be over-leveraged.
Keep in mind that the current ratio, like the other liquidity ratios, is a snapshot in time. The ratio could improve or worsen depending on how a company’s business is performing and how the firm decides to manage its capital structure moving forward.
The Quick Ratio
The quick ratio is often referred to as the “acid-test” ratio by analysts. It is calculated the same as the current ratio, but with a stricter definition on what constitutes a “current asset.” Analysts use this ratio to test a company’s liquidity without including assets that are not as easy to liquidate.
The numerator of the quick ratio includes: cash, marketable securities, and accounts receivable within one year.
Notice how you don’t add inventory to the numerator in this case. This is because inventory can be trickier to liquidate than the other components of the numerator.
The denominator for the quick ratio is still the firm’s current liabilities, wages and accounts payable within a year.
To put it in a mathematical formula, the quick ratio is equal to (cash + marketable securities + A/R)/(current liabilities).
A high quick ratio indicates that a firm may have a lot of cash on hand compared to liabilities. This may be constructive, but odds are that the firm could be putting that cash to work to scale operations, increase R&D, etc.
On the other hand, a low acid test ratio can be concerning for most industries. This means that the firm is highly strapped for cash compared to its level of leverage.
As with any type of fundamental analysis, it’s wise to make sure you’re comparing apples to apples. In finance, that means that you should compare metrics, such as the quick ratio, within sectors or industries to get the most accurate picture.
For example, it makes no sense to compare the quick ratio of a retailer (which relies heavily on inventory) to that of a software company (which should have much less overhead).
The Cash Asset Ratio
The cash asset ratio is nearly identical to the acid-test ratio, except the numerator only includes cash and marketable securities (stocks, bonds, etc.). This is an even more stringent measure of a firm’s liquidity.
The formula for this ratio is (cash + marketable securities)/(current liabilities)
If a firm has $1,000,000,000 worth of marketable securities and cash on its balance sheet and $2,000,000,000 worth of current liabilities, that would indicate that the firm has a cash asset ratio of .5. A high cash asset ratio is usually constructive, as long as the firm has plans to use the assets effectively.
On the other hand, a low cash asset ratio is almost always concerning for the financial prospects of a firm.
Important Liquidity Considerations
It’s wise to not analyze the liquidity of a firm in a vacuum. This means that there should be some context behind the figure you are deriving. For example, a current ratio of 0.85 may be troublesome for one industry but average for another. As a rule, different industries have different standards for the type of assets their companies own and how much debt they carry on their balance sheets.
Along with the liquidity ratios, it’s important to see what direction a firm is headed with its financial health. A lackluster liquidity ratio does not necessarily mean a company is doomed forever, especially if it is strategically leveraging debt to scale its operations.
If a firm is sitting on a lot of cash, an investor should investigate why the company has so much cash and what the firm’s management intends on doing with it. Remember: no two firms or industries are equal.
Where Do I Find This Information?
If you can find a company’s balance sheet, you have everything you need to calculate these ratios.
Finding this information has never been easier, thanks to the internet. Websites like Yahoo Finance and Morningstar can be great resources for digging deeper into the financials of a company.
The balance sheet is available on the 10K and 10Q reports for companies that SEC regulations require to release such data.
A Final Word on Liquidity Ratios
Fundamental analysis requires investors and analysts to take a deeper dive into the financials of a company. While this may take some extra time and effort, it can be well worth it if you are putting large amounts of capital to work.
The liquidity ratios are helpful tools that allow you to understand where a company currently stands financially. They allow you to see the composition of current assets versus current liabilities on a company’s balance sheet.
While the calculations are simple, they can reveal a great deal about the firm’s financial health. But keep in mind, these ratios are snapshots and will change with time.
The liquidity ratios are among the handful of ratios you should understand when performing fundamental analysis. Make sure that you compare apples to apples. Furthermore, look to see that you leverage all of the tools available to modern investors to research these figures.
Have questions on these ratios? Let us know!