Liquidity Ratios: Definition and Examples
Liquidity ratios measure a company’s ability to meet short-term obligations.
One of the most important parts of a company’s financial health is its ability to meet short-term obligations. After all, it doesn’t matter how much long-term potential a company has if it cannot pay its bills. One of the common ways to evaluate this is through liquidity ratios. In this article, we will examine the most common liquidity ratios and explain how they apply in real-world situations.
What are Liquidity Ratios?
Liquidity is a measure of how easily something can be converted into cash. Liquidity ratios, therefore, are a way of gauging how likely a company is to meet its short-term obligations with its cash and other current assets.
A higher number, such as 2 or 3, is usually considered safe and desirable, whereas anything below 1 starts to raise concerns. Of course, interpreting the liquidity ratio will depend on the specific company, its industry, and its competitors.
Common Liquidity Ratios
The three most common liquidity ratios are the Current Ratio, the Quick Ratio, and the Cash Ratio.
Current Ratio = Current Assets / Current Liabilities
This ratio looks at a company’s current assets (such as its cash, accounts receivable, and inventory), and compares them to its current liabilities (such as accounts payable). Anything above 2 is usually considered a healthy number, although this will depend on the specific industry.
An asset or liability is considered “current” if it is expected to be converted into cash (in the case of assets) or paid back (in the case of liabilities) within one year.
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
As you can see, the Quick Ratio (sometimes referred to as the “Acid Ratio”, or the “Acid-Test Ratio”) is the same as the Current Ratio except it specifically excludes Inventory from the calculation of Current Assets. The reason for this is that it is intended to be a more conservative ratio. Inventory can sometimes lose value for reasons such as spoilage, technological obsolescence, or changes in consumer preferences. Think of groceries that go stale, old computers that become outdated, or clothing that goes out of fashion. In those cases, companies may end up selling inventory for less than its value on the balance sheet. By removing inventory from the calculation of Current Assets, the Quick Ratio bypasses this risk.
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
The Cash Ratio is the most conservative of the liquidity ratios, only considering cash and cash equivalents. This ratio is less commonly used, but it provides insight into how well a company could pay off its short-term liabilities if it had to do so almost immediately.
The term “Cash Equivalents” refers to assets that are very low-risk and can be converted into cash very quickly, usually within one or two business days. Examples of assets that might be considered Cash Equivalents include treasury bills, certificates of deposit (CDs), and money market funds.
Real-World Example of Liquidity Ratios
Let’s consider the case of Tesla, Inc. Looking at their annual 10-K filing for 2022 (see image above). Based on this information, we can calculate our three most common liquidity ratios as follows:
- Current Ratio = Current Assets / Current Liabilities
= $40.9 billion / $26.7 billion
= 1.53 - Quick Ratio = (Current Assets - Inventory) / Current Liabilities
= ($40.9 billion - $12.8 billion) / $26.7 billion
= $28.1 billion / $26.7 billion
= 1.05 - Cash Ratio = Cash and Cash Equivalents / Current Liabilities
= $16.3 billion / $26.7 billion
= 0.61
As you can see, the general trend is that the current ratio returns the highest number at 1.53, while the cash ratio returns the lowest number at 0.61. This is because the cash ratio is more conservative as it only accounts for cash and cash equivalents and omits other current assets such as inventory or accounts receivable.
What is a Good Liquidity Ratio?
This depends on the company’s historical track record, its industry standards, and its competitors. In the case of Tesla above, these ratios are fairly typical for an automaker in the US, when compared to competitors such as General Motors or Ford.
In theory, there can be such a thing as a ratio that is “too high”. After all, if a company has very high liquidity ratios, such as a Current Ratio above 5 for example, it could indicate that they are failing to find worthwhile investments for their cash that could generate attractive returns for investors.
On the other hand, if a company has succeeded in growing rapidly, investors might be more willing to tolerate lower liquidity ratios because they have confidence that the company is putting its cash to good use.
Liquidity Ratios vs Solvency Ratios
While liquidity ratios measure a company’s ability to meet short-term obligations, solvency ratios measure a company’s longer-term strength. Solvency ratios do so by comparing a company’s total liabilities (both short-term and long-term) against its total assets or equity. These ratios offer insights into how comfortably a company can manage its long-term obligations, considering all sources of debt.
Popular solvency ratios include the Debt-to-Equity Ratio, which compares total debt to shareholders’ equity, and the Debt-to-Assets Ratio, which captures what percentage of total assets are financed by debt. We will not get into them in this article, but bear in mind that investors will often use both types of tools when evaluating a company’s financial health.
Impact of Economic Conditions on Liquidity Ratios
Liquidity ratios can be affected by broader economic conditions. For instance, during a recession, a company might find it more challenging to liquidate inventory or collect accounts receivable, which would impact its quick ratio. On the other hand, in a booming economy, more liquid assets might be readily available, leading to higher liquidity ratios. As mentioned earlier, forces such as consumer trends and technological changes can also impact liquidity ratios.
Sometimes, specific industries will experience a “liquidity crunch” in which it becomes unusually difficult to raise cash. This can occur in the financial sector, for example, when banks become reluctant to lend to one-another or to clients. Similarly, if an industry is highly dependent on credit for their regular operations, disruptions in liquidity can cause business activity to slow down or even grind to a halt.
This can unfold in many ways, but consider for example a real estate developer that relies on construction mortgages to build real estate; or a car dealership that relies on a line of credit to purchase vehicles. Industries like these can sometimes see liquidity dry up very quickly, due to circumstances (such as a banking crisis) beyond their control.
Why Understanding Liquidity is Crucial
In business, it really is true that “cash is king”. Understanding liquidity is essential for various stakeholders, including:
- Investors: need to gauge the risk associated with an investment, especially in the short-term.
- Creditors: need to evaluate how reliably a borrower could meet their interest and principal payments with short-term cash.
- Managers: need to make informed decisions about how much of their cash they can invest, versus how much they should keep in reserve.
While much attention is paid to revenue and profit, liquidity and cash are ultimately the life-blood of every business, making liquidity ratios an essential tool.
Summary of Key Points
- Liquidity ratios measure a company’s financial strength. Specifically, their ability to meet short-term obligations.
- There are three main liquidity ratios: the current ratio, quick ratio, and cash ratio.
- Of those three, the current ratio is the least conservative, while the cash ratio is the most conservative.
- Generally speaking, a higher ratio is considered “good”, although a very high ratio could indicate a lack of investment in profitable projects.
- What counts as a normal ratio will depend on the specific industry and competitive landscape.
- Sometimes, the ratios for a company or an industry can change significantly based on factors outside their control, such as a general recession or a banking crisis.
By understanding liquidity ratios, stakeholders can gain insights into a company's short-term financial health and make more informed decisions. Whether it's investing, lending, or managing, these ratios form a crucial part of our toolkit as financial analysts.
Additional Resources
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