Liquidity ratio. Interpretation and how to calculate it

Short-term decision making in companies is essential to keep the business operating. These decisions involve taking on debt or making payments in short periods of time to obtain supplies, pay for services and other debts. 

The company must have cash or cash equivalents to meet these payments, and this is called liquidity. The liquidity ratio is used to measure the relationship between current assets and current liabilities. 

What is the Liquidity Ratio?

The liquidity ratio, in a general sense, can be defined as the relationship between the company's capacity to support its short-term debts or current liabilities and its liquid or easily liquid resources, i.e. its current assets.

‍

Types of Liquidity Ratios and how to calculate them. Formulas.

A company's liquidity can be measured from different angles, and with levels of detail appropriate for the various decisions that must be made in the day-to-day running of the business. 

Working Capital or Working Capital

The components of the company's liquidity are included in working capital, working capital, working capital, working capital or turnover fund, all of them denominations that represent the same magnitude, but through different approaches.

Working capital, or working capital, can generally be defined as the difference between current assets and current liabilities, or also as the difference between permanent capital and fixed assets. It represents the money needed in the short term to pay debts maturing in the short term.

This breakdown can be analyzed in the following formula:

Assets = Liabilities + Equity

Assets = Current Assets + Non-Current Assets

Liabilities = Current Liabilities + Non-Current Liabilities

Current Assets + Non-Current Assets = Current Liabilities + Non-Current Liabilities + Shareholders' Equity

Current Assets - Current Liabilities = Current Liabilities + Shareholders' Equity - Non Current Assets

Working Capital = Working Capital

Working capital is a monetary magnitude, which does not allow comparison over time or with other companies. Furthermore, it tends to adapt to the needs of each business, and can even be negative in the case of companies with a high inventory turnover, and with a payment term to customers that is shorter than the payment term to suppliers.

General or Immediate Liquidity

The general liquidity or immediate liquidity ratio measures the relationship between current assets and current liabilities, representing the company's capacity to meet its short-term debts.

Immediate liquidity = Current assets / current liabilities

Acid Test

The acid test liquidity ratio consists of a breakdown of the immediate liquidity ratio to eliminate assets that, although current, may not be converted into cash immediately.

Liquidity acid test = Current assets - Inventories / Current liabilities

Defensive test

The defensive test liquidity ratio or cash ratio consists of a breakdown of the acid test liquidity ratio to eliminate assets that do not directly represent cash or its equivalent.

Defensive test liquidity = Pure current assets (cash or cash equivalents) / Current liabilities

They do not represent cash or its equivalent, but are current assets: inventories or inventory, accounts receivable, short-term investments not made directly in legal tender.

The following represent cash or its equivalent: cash in hand, money in a savings bank or bank checking account, money in easily convertible foreign currency.

Accounts Receivable, Accounts Payable and Inventories

There are specific ratios to measure inventory turnover, accounts receivable turnover and accounts payable turnover, which allow a calculation of the company's financial gap, represented by the days needed to complete the company's cash cycles and make working capital work properly.

Receivables Cycle = 365 days / (Sales / Receivables)

Inventory Cycle = 365 days / (Cost of Sales / Average Inventory or Inventory)

Payment Cycle = 365 days / (Purchases / Trade Payables)

Financial gap = Receivables cycle + Inventory cycle - Payables cycle

‍

Liquidity Ratio Interpretation

For the interpretation of the liquidity ratio, regardless of the level of depth of analysis: general, acid test or defensive test, the following should be taken into account:

Greater than 1

A liquidity value greater than 1 implies that the company can meet its short-term debts with current assets. If it exceeds 3, it is possible that the company has idle resources.

Less than 1

A liquidity value of less than 1 implies that the company is in serious financial trouble, because it cannot meet its immediate obligations with its current assets. In countries with high inflationary indexes and exchange rate problems, this situation is common.

‍

Optimum values of the Liquidity Ratio for the company

Ideally, the company should have all liquidity ratios above 1 and below 3, due to the need to have a financial cushion to meet payments that could not have been foreseen through reasonable risk management. 

In other words, it is necessary to have enough money to face unforeseen circumstances or force majeure, for example: uninsurable losses, unforeseeable layoffs, or unforeseeable temporary situations, such as a pandemic.

When liquidity ratios have values very close to 1, although they represent coverage of current liabilities with current assets, any minor incident, for example, a change in the cycles that make up the financial gap, can cause immediate liquidity problems.

However, when liquidity ratios exceed the value of 3 or even higher, they are clearly indicating that the company has idle resources, which need to be invested, for example, to expand installed capacity, to generate new business, or even to make long-term investments that benefit the company and its partners.

‍

Importance of the Liquidity Ratio in third-party risk management

Third-party risk management includes contractual, legal, accounting and, in the case of large businesses involving frequent movements of cash or cash equivalents, financial aspects. 

For example, this situation occurs in relationships with large customers and suppliers, where liquidity ratios and related indicators are essential to be able to analyze the financial health of these third parties, and to have a reasonable level of security in the operations we carry out with them. 

In addition, knowing the financial gap and liquidity ratios of our main customers and suppliers will allow us to reasonably organize the company's collection, payment and inventory cycles. 

‍