Liquidity ratio is a ratio that evaluates a company’s ability to set off its short-term obligations. Read this blog to learn more about the liquidity ratio.
The ability of a business to convert assets into cash or to get cash—through a loan or cash in the bank—to meet its short-term liabilities or commitments is known as liquidity. Liquidity is a vital component of every firm. A business must have the liquidity to satisfy its short-term obligations. Liquidity ratio assess a company’s capacity to pay down its short-term liabilities.
Liquidity ratios indicate how quickly a corporation can convert assets and use them to pay off debts. The higher the ratio, the easier it is to discharge debts and avoid payment defaults. This is a critical characteristic that creditors look at before making short-term business loans. An organisation that cannot pay its bills impacts its creditworthiness, which impacts the company’s credit rating.
What is Liquidity Ratio?
Liquidity ratios play a crucial role in assessing a debtor’s capacity to settle current debts without relying on external funding. These ratios gauge a company’s ability to meet debt obligations and assess its safety cushion by evaluating metrics such as the current ratio, quick ratio, and operating cash flow ratio.
- Liquidity ratios are vital financial metrics used to assess a debtor’s capability to settle current debt obligations without external capital.
- Common liquidity ratios: quick ratio, current ratio, and days sales outstanding.
- Liquidity ratios evaluate a company’s capacity to handle short-term obligations and cash flows.
- Solvency ratios focus on the longer-term ability to repay ongoing debts.
Uses of Liquidity Ratio
- Liquidity ratio are used to assess a company liquidation services condition. High equity is often regarded as beneficial to the firm because it can meet present obligations if it has a significant equity reservoir.
- However, it is also true that too much liquidity can harm the firm. As a result, organisations should maintain an optimal mix of stock and debt. Because liquidity ratios reveal the present mix of stock and debt, managers, owners, and investors may comprehend the actual state of the company’s health and make appropriate decisions.
Why Are There Several Liquidity Ratio Used in India?
- There are multiple liquidity ratios used in financial analysis because each ratio provides a different perspective on a company’s liquidity position. Different ratios consider different components of a company’s current assets and liabilities. Some common liquidity ratios used in India include the current ratio, quick ratio, and cash ratio.
- The current ratio measures the company’s ability to cover its short-term obligations using all current assets. The quick ratio focuses on the company’s ability to cover short-term obligations using only the most liquid assets, excluding inventory. The cash ratio assesses the company’s ability to cover its short-term liabilities using only cash and cash equivalents. Each ratio provides valuable insights into different aspects of a company’s liquidity position.
What Happens If Ratios Show a Firm Is Not Liquid?
- If liquidity ratio indicate that a firm is not liquid, it means that the company may face challenges in meeting its short-term financial obligations. This can lead to difficulties in paying suppliers, meeting payroll, or servicing debt. In such situations, the company may need to take immediate actions to improve its liquidity position.
- To address liquidity issues, a company can explore various strategies. It may consider optimising its cash flow management, negotiating more favourable payment terms with suppliers, seeking additional financing, or selling non-essential assets to generate immediate cash. It is crucial for the company to develop a well-defined liquidity management plan to ensure its short-term financial stability.
Importance of Liquidity Ratio
- The liquidity ratio is a valuable financial metric that provides insights into a company’s financial position.
- It helps gauge the cash availability and short-term financial status of the company.
- A higher liquidity ratio indicates greater stability, while a poor ratio poses a risk of financial harm.
- This ratio offers a comprehensive understanding of the company’s operational system, including the effectiveness of sales and inventory management.
- It enables the company to improve production processes, optimise inventory storage, and manage overhead expenses more efficiently.
- Considering the liquidity ratio, a company can enhance its management efficiency in meeting the demands of potential creditors.
- The ratio aids in determining and meeting the company’s working capital requirements, contributing to overall financial stability.
Limitations of Liquid Ratio
- In addition to the quantity of liquid assets, the quality of those assets is also crucial when considering liquidity ratio.
- It is recommended to evaluate other accounting metrics alongside liquidity ratios to obtain a comprehensive analysis of a company’s liquidity strength.
- The inclusion of inventory in liquidity ratio calculations can lead to inaccuracies due to potential overestimation and the negative impact of excessive inventory on sales.
- Relying solely on inventory calculations may not provide an accurate depiction of a company’s true liquidity.
- The liquidity ratio can be influenced by creative accounting practices as it focuses solely on balance sheet information.
- To gain a comprehensive understanding of an organisation’s financial position, analysts need to go beyond balance sheet data and perform a thorough liquidity ratio analysis.
Examples Using Liquidity Ratio
Liquids, Inc. & Solvents, Co.
Say there are 2 hypothetical companies—Liquids Inc. and Solvents Co.—that operate in the manufacturing sector, specifically industrial glues and solvents. The following table shows their balance sheets in millions of Indian Rupees:
| Liquids Inc. | Solvents Co. | |
| Cash & Cash Equivalents | ₹410 | ₹82 |
| Marketable Securities | ₹410 | ₹164 |
| Accounts Receivable | ₹820 | ₹164 |
| Inventories | ₹820 | ₹410 |
| Current Assets | ₹2,460 | ₹820 |
| Plant and Equipment | ₹2,050 | ₹5,330 |
| Intangible Assets | ₹1,640 | ₹0 |
| Total Assets | ₹6,150 | ₹6,150 |
| Current Liabilities | ₹820 | ₹2,050 |
| Long-Term Debt | ₹4,100 | ₹820 |
| Total Liabilities | ₹4,920 | ₹2,870 |
| Shareholders’ Equity | ₹1,230 | ₹3,280 |
Liquids, Inc.:
- Current ratio: ₹2,460 / ₹820 = 3.0
- Quick ratio: (₹2,460 – ₹820) / ₹820 = 2.0
- Debt to equity: ₹4,100 / ₹1,230 = 3.33
- Debt to assets: ₹4,100 / ₹6,150 = 0.67
Solvents, Co.:
- Current ratio: ₹820 / ₹2,050 = 0.40
- Quick ratio: (₹820 – ₹410) / ₹2,050 = 0.20
- Debt to equity: ₹820 / ₹3,280 = 0.25
- Debt to assets: ₹820 / ₹6,150 = 0.13
Conclusions
- Liquids, Inc. has a high degree of liquidity. For every ₹1 of current liabilities, it has ₹3 of current assets. The company also has sufficient liquid assets (excluding inventories) with ₹2 for every ₹1 of current liabilities.
- However, Liquids, Inc. has a high level of financial leverage. Debt is more than three times its equity, and about two-thirds of its assets are financed by debt. Additionally, a significant portion of its non-current assets consists of intangible assets. The company’s debt-to-tangible assets ratio is 0.91, meaning that over 90% of its tangible assets have been financed through borrowing. Overall, Liquids, Inc. has good liquidity but faces high leverage.
- Solvents, Co. faces liquidity challenges. Its current ratio is 0.40, indicating insufficient liquidity, with only ₹0.40 of existing assets available for every ₹1 of current liabilities. The quick ratio is even lower, with only ₹0.20 of liquid assets for every ₹1 of current liabilities.
- However, Solvents, Co. maintains a comfortable level of financial leverage. Debt represents only 25% of its equity, and only 13% of its assets are financed by debt. Moreover, all of its assets are tangible assets. As a result, the company’s debt to tangible assets ratio is approximate one-seventh that of Liquids, Inc. (around 13% vs. 91%). Despite facing liquidity challenges, Solvents, Co. has a comfortable debt position.
How Does Liquidity Differ From Solvency in the Indian Context?
- Liquidity and solvency are two important concepts in financial analysis, and they have distinct meanings in the Indian context.
- Liquidity refers to a company’s ability to meet its short-term financial obligations, such as paying off debts and covering day-to-day expenses. It focuses on the availability of cash and other liquid assets that can be readily converted into cash. A company with good liquidity can easily settle its short-term liabilities without disruption to its operations. Liquidity ratios, such as the current ratio and quick ratio, help assess a company’s liquidity position.
- On the other hand, solvency looks at a company’s long-term financial health and its ability to meet its long-term obligations. It focuses on whether a company has sufficient assets to cover its debts and liabilities in the long run. Solvency ratios, such as debt to equity ratio and debt to assets ratio, evaluate a company’s ability to repay its long-term debts and sustain its operations in the long term.
Types of Liquidity Ratio
Current Ratios
- The current ratio is the most straightforward liquidity ratio to compute and understand. Anyone may easily recognise the line items for current assets and current obligations on a balance sheet. The current ratio is calculated by dividing current assets by current liabilities.
Current Ratio = Current Assets/Current Liabilities
- Current ratios can differ depending on the industry, firm size, and economic conditions. Consumer goods sectors, which have predictable, recurring revenue, frequently have lower current ratios, whereas cyclical industries, such as construction, have high current ratios. Current ratios might vary amongst organisations, even within the same industry.
| Current assets | Current liabilities | Current ratio (current assets / current liabilities) |
|---|---|---|
| ₹ 260 crores | ₹ 130 crores | ₹ 260 crore / ₹ 130 crores = 2:1 |
Quick Ratios
- Although commodities take longer to convert into cash and planned expenditure funds cannot be used to settle current liabilities, the quick ratio varies from the liquidity ratios in that they do not include inventory as well as prepaid expense accounts.
- Nevertheless, depending on the organisation, some organisations may view inventories as a fast asset, albeit these instances are uncommon. A stricter liquidity assessment than even the current ratio is the fast ratio. Current assets serve as the numerator, and present liabilities serve as the denominator in both calculations.
- However, the fast ratio only considers specific current assets. It considers more liquid assets, including cash, accounts receivable, and marketable securities. Current assets, such as inventories and prepaid expenses, are excluded since they are less liquid. As a result, the quick ratio is a more accurate indicator of a company’s capacity to meet its short-term obligations.
Quick Ratio = (Cash+ Debtors+ Marketable Securities)/ Currents Liabilities
| Particulars Of current assets | Amount in crore |
|---|---|
| Cash and equivalent | ₹65,000 |
| Marketable securities | ₹15,000 |
| Accounts receivables | ₹35,000 |
| Inventory | ₹45,000 |
| Total current assets | ₹160,000 |
| Total current liabilities | ₹60,000 |
| Current ratio | As per formula 1 = (₹65,000 + ₹15,000 + ₹35,000)/ ₹60,000
= ₹115,000/₹60,000 = 1.91 As per formula 2 = (₹160,000 – ₹45,000)/₹ 60,000 = ₹115,000/₹60,000 = 1.91 |
Cash Ratios
- The liquidity test is made more difficult by the cash ratio. This ratio only considers a company’s most liquid assets, cash and marketable securities. They are the assets that a corporation has the most updated version to satisfy short-term obligations.
Cash ratio = (Cash+ Marketable Securities)/ Current Liabilities
- In the worst-case situation, the cash ratio resembles a gauge of a company’s value — say, the corporation will exit the business. It informs analysts and creditors of the value of current assets that can be turned swiftly into cash and the percentage of a company’s current obligations that can cover those cash and approaching assets.
| Particulars Of liquid assets | Amount in crore |
|---|---|
| Cash and equivalent | ₹ 1,65,000 |
| Marketable securities | ₹ 75,000 |
| Accounts receivables | ₹ 90,000 |
| Inventory | ₹ 1,00,000 |
| Current liquid assets | ₹ 4,30,000 |
| Particulars Of Current liabilities | Amount |
| Bills payables | ₹ 90,000 |
| Bank overdraft | ₹ 80,000 |
| Outstanding expenses | ₹ 30,000 |
| Creditors | ₹ 1,00,000 |
| Total current liabilities | ₹ 3,00,000 |
| Cash ratio | (₹ 1,65,000 + ₹ 75,000)/₹ 3,00,000
= ₹ 2,40,000/₹ 3,00,000 =0.8 |
Basic Defence Ratios
This ratio calculates the number of days a company can sustain its cash expenses without relying on outside finance.
(Cash+ Receivables+ Marketable Securities)/ (Operating expenses+ Interest+ Taxes)/ 365
| Particulars of liquid assets | Amount in crore |
|---|---|
| Cash and equivalent | ₹1,05,000 |
| Marketable securities | ₹55,000 |
| Accounts receivables | ₹80,000 |
| Current liquid assets | ₹2,40,000 |
| Particular of daily operational expenses | Amount |
| Annual operating cost | ₹5,00,000 |
| Non-cash expenses | ₹70,000 |
| Daily operational expenses | ₹4,30,000/365 = 1178 |
| Basic defence ratio | ₹2,40,000/1178
= 203 |
Solvency Ratio vs. Liquidity Ratio
- Solvency ratios, unlike liquidity ratio, assess a company’s capacity to fulfill long-term debts and overall financial obligations. Solvency pertains to the company’s ability to meet debt responsibilities and sustain its operations, whereas liquidity primarily focuses on current or short-term financial matters.
- For a company to be considered solvent, its total assets must exceed its total liabilities, while for a company to be considered liquid, its current assets must surpass its current liabilities. Although solvency and liquidity are not directly interrelated, liquidity ratio can provide an initial indication of a company’s solvency.
- To determine a company’s solvency, the solvency ratio is computed by dividing the net income and depreciation by the sum of its short-term and long-term liabilities. This ratio serves as an indicator of whether a company’s net income is sufficient to fulfill its overall liabilities. Typically, a company with a higher solvency ratio is regarded as a more favorable investment.
The Usefulness of Liquidity Ratio
The liquidity ratio has a direct impact on a company’s credibility and credit rating. Persistent failures to repay short-term liabilities can result in bankruptcy. Therefore, this ratio holds significant importance in ensuring the financial stability of a company and its creditworthiness.
Examples Using Liquidity Ratio
We will utilise a few liquidity ratio to illustrate their efficacy in evaluating the financial state of a company. Let’s examine two hypothetical companies, Liquids Inc. and Solvents Co., operating in the manufacturing sector, specifically in industrial glues and solvents. Below are the asset and liability figures from their balance sheets, expressed in millions of dollars.
|
Balance Sheets for Liquids Inc. and Solvents Co. |
||
| (in millions of dollars) | Liquids Inc. | Solvents Co. |
| Cash & Cash Equivalents | $5 | $1 |
| Marketable Securities | $5 | $2 |
| Accounts Receivable | $10 | $2 |
| Inventories | $10 | $5 |
| Current Assets (a) | $30 | $10 |
| Plant and Equipment (b) | $25 | $65 |
| Intangible Assets (c) | $20 | $0 |
| Total Assets (a + b + c) | $75 | $75 |
| Current Liabilities* (d) | $10 | $25 |
| Long-Term Debt (e) | $50 | $10 |
| Total Liabilities (d + e) | $60 | $35 |
| Shareholders’ Equity | $15 | $40 |
In our example, it is important to note that we will consider current liabilities as consisting solely of accounts payable and other liabilities, excluding any short-term debt.
Conclusion
If you have any queries regarding the Liquidity ratio other than the given information or any other tax or audit-related information, feel free to contact us at Vakilsearch! We are happy to help you.
FAQs
What is the ideal Current Ratio?
When the current ratio exceeds 1, it is deemed as an ideal scenario. A higher current ratio signifies a stronger liquidity position for the company.
What is considered SLR?
According to RBI guidelines, government securities like bonds, cash, and gold are recognised as assets that fulfill the requirement of maintaining SLR (Statutory Liquidity Ratio).
What is Liquidity and Why is it Important for Firms?
Liquidity pertains to the ease and efficiency of acquiring cash to settle immediate financial responsibilities such as bills and short-term obligations. Assets such as stocks and bonds, which can be easily sold, are also deemed liquid (although cash remains the most liquid asset). It is essential for businesses to possess an adequate level of liquidity to meet their financial obligations, pay vendors, maintain payroll, and sustain day-to-day operations smoothly.
How Does Liquidity Differ from Solvency?
Liquidity is the capacity to meet immediate financial obligations, while solvency relates to a company's capability to fulfill long-term obligations. In the case of a company, this typically involves the ability to repay interest and principal on debts, such as bonds, or meet long-term lease commitments.
Why are there Several Liquidity Ratios?
Essentially, all liquidity ratios assess a company's capacity to meet short-term obligations by dividing current assets by current liabilities (CL). The cash ratio focuses solely on the available cash divided by CL, whereas the quick ratio incorporates cash equivalents (such as money market holdings), marketable securities, and accounts receivable. On the other hand, the current ratio encompasses all current assets in the calculation.
What Happens if Ratios Show a Firm is not Liquid?
In certain situations, even financially sound companies can experience a liquidity crisis if circumstances make it challenging to fulfill short-term obligations, such as loan repayments, employee salaries, or supplier payments. An illustration of a widespread liquidity crisis in recent history is the global credit crunch of 2007-2009, during which numerous companies struggled to obtain short-term financing to meet their immediate financial commitments.
Who faces liquidity risk?
Companies or organisations that have insufficient liquid assets to meet their short-term financial obligations face liquidity risk.
What is the ideal liquidity ratio?
The ideal liquidity ratio depends on the industry and specific circumstances, but generally, a current ratio of 2:1 is considered favourable, indicating sufficient liquidity to cover short-term liabilities.
What are the two types of liquidity risks?
The two types of liquidity risks are funding liquidity risk, which refers to the inability to obtain the necessary funding to meet obligations, and market liquidity risk, which pertains to the difficulty in buying or selling assets without causing significant price changes.
