What are “Liquidity Ratios”?
Liquidity refers to a company’s capacity to meet its short-term (usually a year) financing obligations and liquidity ratios assess its ability to do so. More specially, these ratios tell us whether a company has sufficient current assets to meet its current liabilities or not. If not, then the company will have to use long term finance, in the form of equity or debt. It might be noted that net debt and operating working capital (OWC) are useful indicators of a company’s liquidity.
Liquidity ratios are common in credit analysis. Some of the common liquidity ratios are:
- Current Ratio
- Cash Ratio
Key Learning Points
- Liquidity ratios assess a company’s ability to meet its short-term debt obligations.
- The commonly used liquidity ratios are: current ratio, OWC/Sales and the cash ratio.
- The current ratio is calculated as Current Assets/Current Liabilities. A current ratio of less than 1 is cause for worry.
- The OWC/Sales ratio compares OWC with sales. Companies should avoid a high OWC/sales ratio.
- The cash ratio is a more conservative measure of liquidity. It is calculated as Cash+ Marketable Securities /Current liabilities.
Liquidity Ratios – Examples
Given below are some common liquidity ratios:
This ratio measures the capacity of a company to pay off its current liabilities (accounts payable etc.) by liquidating its current assets (cash, current investments, inventories etc.) and converting the same into cash. It answers the crucial question of whether a firm can avoid being insolvent in the short turn or not, or if a company has sufficient current assets to meet its short-term financing obligations.
Current Ratio = Current Assets/Current Liabilities
A company that has a current ratio of more than 1 indicates that it has adequate current assets to cover its current liabilities.
Operating working capital/sales ratio
Operating working capital (OWC) is defined as operating current assets less operating current liabilities. OWC indicates whether a company has cash tied up on its operations or has enough cash to meet its short-term funding requirements.
A positive OWC indicates that cash is tied up in the operations of the company, and short-term funding is required. A negative OWC indicates that the company is being effectively funded by its suppliers. From a liquidity standpoint, a negative OWC is better than a positive one.
OWC/Sales ratio = OWC/Sales
This ratio compares OWC with sales. Companies should avoid OWC/sales from growing too high. A High OWC/sales ratio indicates that a lot of short-term assets are locked up in the business, which ties up cash and reduces liquidity.
The cash ratio is a more conservative measure of liquidity. It tests a company’s ability to repay short-term obligations using just cash and marketable securities. This ratio gives a worst-case scenario by focusing solely on cash that is readily available.
Cash Ratio = Cash + Marketable Securities/Current liabilities
Net debt measures the ability of a company to pay off all of its debt as if it were due today.
Net debt = Total debt (Short Term + Long Term Debt) – Cash and Cash Equivalents
Net debt is not a liquidity ratio but a useful indicator of a company’s liquidity. Suppose, there are two companies that have the same total debt and one of them has lower net debt, then it can be implied that this company has more surplus liquid financial assets which indicates better or higher liquidity.
Example – Liquidity Ratios
Given below is a workout of liquidity ratios of two companies with similar sales figures.
Based on the information above, given below are key liquidity ratios and metrics.
Company B has a negative OWC/Sales ratio. This indicates that company B has better access to short-term funding when compared to Company A. Further, it also has a current ratio greater than 1, which indicates that this company’s current assets are adequate to pay off its current liabilities. Moreover, Company B also has a better cash ratio, lower net debt and negative OWC/Sales ratio. Consequently, overall, Company B has more liquidity than Company A.
Company A has a higher OWC/sales ratio than Company B. It should avoid this ratio from growing too high.