Someone who mentions liquidity in investing is usually referring to the ability of an entity to convert its assets into cash. In other words, a business analyst might want to know how quickly a company can get its hands on funds to cover its outstanding bills. It's important for companies, and a sign of their financial health, to have enough cash to cover their payment obligations on an ongoing basis without needing to go to outside sources for capital.
In business or accounting, the ability of a business to pay its short-term obligations and debts when they are due is usually quantified by calculating and reviewing the current ratio as a liquidity ratio or percentage of liabilities.
The liquidity of a business firm is usually of particular interest to its short-term creditors since the amount of existing liquidity says a lot about the company's ability to pay those creditors. Generally, the higher the value of the liquidity ratio, the greater the margin of safety a company possesses in its ability to pay its bills.
Some Key Liquidity Ratios
A handful of financial ratios measure the liquidity of the firm, with all information coming from your balance sheet. Those ratios include the current ratio, the quick ratio or acid test, and the interval measure or burn rate.
- The simplest is the current ratio, which equals total current assets divided by total current liabilities. It borrows from the investing definition because it assumes all the assets can be converted instantly into cash, which is often not the case. A value of over 100 percent is not unusual when calculating the current ratio.
- The quick ratio, or acid test, measures a business' ability to meet current liabilities from assets that can be readily sold, although it is preferable to meet these obligations from cash flow. The quick ratio deducts inventories and prepayments from current assets, then divides them by current liabilities.
- Operating cash flow ratio is the ability of the company to satisfy current debt from current income, rather than asset sales. It is a two-step calculation. Operating cash flow is calculated by adding noncash expenses (usually depreciation expenses) and changes in working capital. The ratio is achieved by dividing operating cash flow by current liabilities.
- The interval measure, also known as the burn rate, looks at the number of days a company can operate using only cash on hand. It is similar to the current ratio and quick ratio in its concern with how easily a company can satisfy its current debt obligations. The burn rate is, however, sometimes preferred to the quick and current ratios because it provides an approximation of the actual number of days, while the other ratios provide a value that indicates the ability and ease of making the payments. The interval measure is calculated by dividing quick assets, or those assets that can be immediately converted into cash, by daily operating expenses.
Also useful is net working capital or working capital, which is the total aggregate amount of all current assets less all current liabilities, measuring the short-term liquidity of a business. It's also an indicator of the ability of the company's management to use assets efficiently.
Using and Interpreting Ratios
The results of one ratio calculation by itself will not reveal much about a company, because the answer represents only one point in time. Many companies calculate a variety of ratios each month and then compare the changes over time to discern whether the company is moving in a positive direction financially or experiencing signs of difficulty.
Another important use of ratio analysis is to compare results externally. Companies in the same industry, especially direct competitors, can gain a wealth of insight when comparing ratios to the same ratios of other companies, or ratios taken from industry averages.
Whether using ratios internally or externally from several different time periods, verify that the ratios are calculated using the same components each time, or you'll find that the comparisons are no longer meaningful because they're not measuring apples to apples.
While some business owners consider all assets in calculating these ratios, some analysts only use the most liquid assets, as they are looking at a worst-case scenario.