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Liquidity Ratio In Detail

What is a Liquidity Ratio?

A liquidity ratio is a measurement that indicates how much cash is readily available to a business so that it may pay its obligations and debts. There are a few different formulae for calculating liquidity ratios that businesses might employ in order to assess their many assets and obligations. The majority of the time, a company's liquidity ratios will indicate the extent to which it is able to pay off its short-term debts or commitments rather than its long-term ones. If a firm has a low liquidity ratio, it is usually an indication that the company does not have sufficient cash on hand to pay their obligations. On the other hand, if the liquidity ratio is high, it is more probable that the company has sufficient liquid assets to cover its financial needs.

In addition to businesses that want to keep track of their own financial well-being, creditors, banks, and other organizations that lend money use liquidity ratios to decide whether or not a firm is a good investment or whether or not it is capable of repaying a loan in a timely manner.

Why liquidity ratios are important:

Reviewing your company's balance sheets and sales reports on their own aren't enough to give you a complete understanding of the company's financial status; you also need to look at liquidity ratios. It is imperative that you have a clear understanding of how much actual cash or assets that can be swiftly liquidated into cash you have in contrast to your debt and expenses if you wish to maintain a good financial state for your firm.

In addition, you can utilize comparative liquidity ratios to examine how your assets and liabilities stack up against those of prior months, quarters, or years. Performing an examination of comparisons can assist you in determining whether or not the cost-cutting measures or tactics for raising income have been successful.

Types Of Liquidity Ratio

1) Current Ratio

The current ratio is a common statistic that is utilized all around the sector to evaluate a company's short-term liquidity in relation to its accessible assets and pending liabilities. In other words, it indicates whether or not a corporation is able to create sufficient cash flow to pay off all of its debts whenever they become due. It is a method that is used all over the world to evaluate how a firm is doing financially in general.

The range of current ratios that are considered healthy vary according on the type of business, but in general, a ratio that falls within the range of 1.5 to 3 is regarded to be in good shape. If the ratio value is less than 1, it is possible that the company is experiencing liquidity challenges; nevertheless, the company may not be facing an extremely dire situation if it is able to find other kinds of financing. If the ratio is greater than three, it may suggest that the company is not effectively managing its working capital or is inefficiently utilising the assets it currently possesses.

Formula:

2) Quick Ratio

The fast ratio determines whether or not a corporation has sufficient liquid assets to satisfy its short-term financial commitments. To put it another way, the quick ratio is a measurement of an organization's liquidity that is used in accounting. It is also known as the acid test ratio because it evaluates a company's capacity to transform its rapid assets into instant cash. This ability is tested by the ratio. The ratio compares the total value in rupees of liquid assets that are available to the total value in rupees of current obligations. The assets known as liquid assets or fast assets are those that can be immediately converted into cash with a minimal effect on the price that is received in the open market. On the other hand, current liabilities are defined as those expenses that must be paid within the next year.

The calculation of the quick ratio involves taking into account both current assets and current liabilities. The ratio of 1:1 is considered to be optimum. Anything lower than that number implies that the corporation has a low level of liquidity.

Formula:

3) Cash Ratio

The cash ratio, also known as the cash asset ratio, is a liquidity statistic that indicates a company's capacity to pay off its short-term debt commitments using its cash and cash equivalents. The cash ratio is frequently referred to as the current asset ratio. The cash ratio is a measure of a company's liquidity that is considered to be more stringent and conservative than other liquidity ratios such as the current ratio and the quick ratio. This is because the cash ratio is calculated using only cash and cash equivalents, which are considered to be the most liquid assets that a company possesses.

Formula:

4) Defensive Interval Ratio

The defensive interval ratio is the ratio that measures the number of days within which the company can continue its working without the requirement of using either its non-current assets or the outside financial resources. This ratio can be calculated by dividing the total current assets of the company with its daily operating expenses.

Formula:

5) Time Interest Earned Ratio

The ability of an organization to meet its financial commitments is quantified by a ratio known as the times interest earned ratio. Lenders frequently analyze the ratio to determine whether or not a potential borrower can afford to take on any additional debt and whether or not the borrower should be approved for the loan. The earnings of a company that can be put toward paying down the interest expense on debt are the earnings that are used in the calculation of the ratio. The amount of interest expense is the other factor in the calculation.

Formula:

6) Capex To Operating Cash Ratio

The CAPEX a.k.a Capital Expenditure to Operating Cash Ratio is a metric that determines how much of a company's cash flow from operations is going toward capital expenditures. For example, building a production facility, introducing a new product line, or restructuring a division are all examples of the types of capital-intensive initiatives that fall under the category of such investments.

In most cases, the ratio is an accurate way to assess how much of an emphasis a company places on expansion. Smaller organizations that are still growing and expanding will typically have a greater CAPEX to Operating Cash Ratio than larger companies since smaller companies are more likely to invest more in research and development. If a company's ratios are getting lower, it can be an indication that the business has attained maturity and is no longer focusing on rapid expansion.

Formula:

7) Operating Cash Flow Ratio

Using this ratio, one may determine how much cash a company generates as a direct result of its sales. It is preferable to have an operating cash flow number that is greater than one because this indicates that a company is successful and has sufficient funds to continue operations as usual. The amount of a company's cash flow ratio ought to improve over time as the company exhibits increasing levels of financial growth.

Formula:

8) Working Capital Ratio

The working capital ratio is an indicator of both the operational effectiveness of a business and the state of its finances in the short term. To determine a company's working capital ratio, just divide the company's current assets by its current liabilities

Formula:

9) Cash From Operating Activities to Current Liabilities

The operating cash flow ratio is a measurement that determines whether or not a firm is able to pay its current liabilities with the cash that it has generated from its operating activities. To determine it, divide the cash flow from operations by the company's current obligations. The result is the operating cash flow ratio. The operating cash flow ratio estimates the number of times that current liabilities may be paid off using net operating cash flow as the source of funds.

Formula:

Cash From Operating Activities to Current Liabilities

10) Average Days sales Outstanding

The number of days that sales are outstanding is known as the days sales outstanding (DSO) statistic. This metric is used to determine how effective a company is at collecting cash from customers who purchased on credit.

DSO is the number of days, on average, that it takes a business to recoup cash payments from consumers who paid using credit. The indicator is often reported on an annual basis so that it may be compared more easily.

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11) Average Days payable Outstanding

The number of days that an organization waits, on average, before paying outstanding supplier or vendor bills for purchases made on credit is measured using a metric known as days payable outstanding (DPO).

The DPO metric is frequently used as a stand-in for the bargaining power of the buyer. Bargaining power refers to the degree to which an organization is able to apply pressure in the process of negotiating advantageous terms with suppliers and vendors .

Formula:

12) Average Days Inventory Outstanding

Days Inventory Outstanding (DIO) is a metric that calculates the average number of days remaining on an inventory before a company needs to purchase new supplies.

DIO is frequently measured to improve a company's go-to-market, sales & marketing, and product pricing strategies based on previous consumer demand and spending trends. This is done by analysing data from DIO reports.

Formula:

13) Cash Conversion cycle

The cash conversion cycle, often known as the CCC, is an essential indicator for a company owner to be familiar with. There is another name for the CCC, and that is the net operating cycle. This cycle provides the owner of a company with information regarding the typical number of days required to first purchase inventory and then turn that inventory into cash. In other words, it is a measurement of the amount of time it takes for a company to purchase supplies, transform those supplies into a product or service, sell those products or services, and collect money owed to the company (if needed).

Formula:

Importance Of Liquidity Ratio

1)-Assess your capacity to meet short-term obligations.

Investors and creditors use liquidity measures to determine if and to what extent a company can meet its short-term obligations. A ratio of one is preferable to one that is less than one, but it isn't optimal.

Higher liquidity ratios, such as 2 or 3, are preferred by creditors and investors. The higher the ratio, the more probable a business will be able to meet its short-term obligations. A ratio of less than one indicates a negative working capital situation and the possibility of a liquidity crisis.

2)-Assess creditworthiness

3)-Evaluate creditworthiness

Liquidity ratios will be used by investors to determine whether a company is financially healthy and worthy of their investment. Working capital constraints will have a negative impact on the remainder of the company. A business must be able to pay its short-term debts with considerable flexibility.

Low liquidity ratios are a danger flag, although the adage "the higher, the better" only holds true to a point. Investors will eventually wonder why a company's liquidity ratios are so high. Yes, a company with an 8.5 liquidity ratio will be able to pay its short-term bills with confidence, but investors may consider such a ratio excessive. An unusually high ratio indicates that the company has a lot of liquid assets.

Pros and Cons of Liquidity Ratio

Pros

It is helpful to obtain an insight of how the company is doing in terms of its liquidity.
It demonstrates how asset-rich the company is at the present time.
It displays the amount of debt that can be paid off only with the cash that is now available.
It is helpful to gain an understanding of the company's strengths.
It gives an indication of how quickly a corporation can clear its debts.
It is helpful to have a good understanding of how quickly a company can turn its inventory into cash.
If your firm is running a deficit, it is helpful to have an idea of how much cash and current assets you will require.
It reveals the amount of ideal money you currently have available to you.
It demonstrates the amount of your current assets that are being utilised in an effective manner.
It reveals the quantity of stock that you have stored away in your facility.

Cons

Utilizing the ratio on its own is not a smart course of action at all.
Different types of businesses fall under several categories of industry. Therefore, the ratio of one company cannot be compared to that of other companies operating in a different industry.
Because different accounting standards and evaluation methodologies are used for inventories, the values of the Ratios can fluctuate.
As time passes, the value of inventories shifts, which may cause the ratio to shift as well.
Ratios are determined using facts from the past, whereas analysts are responsible for making decisions on the future.

Summary of Liquidity Ratio

Liquidity ratios are an important class of financial measures that are used to determine a debtor's capacity to pay down current debt commitments without borrowing additional funds from outside sources.
The quick ratio, the current ratio, and the days sales outstanding are three examples of popular liquidity ratios.
Solvency ratios are concerned with a company's longer-term ability to pay ongoing debts, whereas liquidity ratios are concerned with a company's ability to cover short-term obligations and cash flows. Liquidity ratios can be found by dividing a company's current assets by its current liabilities.