Liquidity Ratio Analysis | Planergy Software (2024)

As a business owner, you understand the importance of having access to accuratefinancial statements. But the typicalfinancial statementswhich include income statements andbalance sheetsonly tell a portion of the story.

To get a better handle on how your business is performing financially, consider using accounting ratios. With dozens of ratios available to choose from, you can obtain detailedmetricsand KPIs on things like company profit margin,working capital, accounts receivableturnover, and inventory movement.

You can also get some much-needed insight into the liquidity of your business by using a series of specialized ratios which can show you how well you can meet yourshort-termfinancial obligations, such as payroll, rent, and taxes.Liquidity ratiosconcentrate oncurrent assetsand liabilities, not concerned with long-term assets that cannot be converted into cash quickly, norlong-term liabilitiesthat are not payable within the year’s time.Liquidity ratiosare important for a variety of reasons, including the following:

• Ability to pay bills – If all of yourcurrentobligationscame due today, do you have enoughcurrent assetsin place to pay them without resorting to credit?Liquidity ratioswill tell you if you haveenough cashto pay your bills.
• Reassure creditors and financial institutions – Are you applying for credit from a vendor, or trying to obtain a business loan? If so, one of the first things that they’ll look at is your liquidity. The number one thing that a potential creditor wants to know is whether your business can repay a loan, while a vendor will want to know that your business can pay its bills on time and in full.
• Attract investors – Like creditors, potential investors will want to see that your business can pay its bills on time. But investors also look at highliquidity ratioswith caution as well, since a higher-than-normal result can point to the possibility that cash is not being used properly.

These are just a few of the reasons why calculating yourcompany’sliquidityratioand understanding the results of that calculation are so important for both small businesses and global enterprises. While a large corporation may want a goodliquidity ratioto attract quality investors, small business owners want to know that they have enough assets on hand to pay any bills that may come due in theshort term.

Luckily, calculatingliquidity ratiosis a quick and easy process, giving you the information you’re looking for in minutes. There are numeroustypes ofliquidity ratios, with threecommonliquidity ratiosused most frequently. Though each of these ratios is similar, they offer differing levels of detail.

Current Ratio

Thecurrent ratiois the most inclusive of theliquidity ratios, providing you with detailed information on the liquidity of your business by measuring the ability of your business to paycurrent liabilitiesonly usingcurrent assets. Commoncurrent assetsthat should be included in thecurrent ratiocalculation include the following.

• Cash andcash equivalentssuch asmarketable securities
• Accounts receivable
• Prepaid expenses
• Inventory

When calculating thecurrent ratio, you’ll only usecurrent liabilitiesor liabilities that are due and payable within a year. These liabilities can include the following.

• Accounts payable
• Employee payroll
• Taxes
• Accrued liabilities
• Anyshort-termdebt(due within 12 months)

How to calculate thecurrent ratio

Thecurrent ratioformula is simple. Simply take yourcurrent assettotal and divide the total by yourcurrent liabilitytotal.

The simplest ratio to complete; thecurrent ratiocalculation is:

Current Assets/Current Liabilities=Current Ratio

Because thecurrent ratioincludes ALL of your company’scurrent assets, there is no need to take individual totals of yourcurrent assetssuch as cash or inventory. You can simply use thecurrent assetsandcurrent liabilitiestotals that can be found on yourbalance sheetto calculate thecurrent ratio.

When reviewing results, a goodcurrent ratiois usually anywhere between 1.2 and 2, with 1.2 indicating that you have an equal amount ofcurrent assetsandcurrent liabilities, while acurrent ratioof 2 indicates that you have twice as much incurrent assets.

Quick Ratio

Thequick ratiois also known as theacid-test ratioand looks at your ability to pay offshort-termliabilitieswithquick assets; or assets that can be converted to cash within 90 days. But unlike thecurrent ratio, thequick ratiodoes not include certain assets such as real estate, inventory, andprepaid expenses, because they are unlikely to be converted intoliquid assetsquickly. Many companies choose to use thequick ratioover thecurrent ratiobecause it provides a more accurate depiction of a company’s true liquidity.

How to calculate thequick ratio

You can calculate thequick ratioby adding cash andcash equivalents, currentaccounts receivable, andshort-terminvestments and dividing that total by yourcurrent liabilities.

Quick Ratio= (Cash +Cash Equivalents+Accounts Receivable+Short-TermInvestments) /Current Liabilities

1 is considered a goodquick ratio, though creditors prefer aquick ratioof at least two, which increases the likelihood that they will be paid on time.

Cash Ratio

Thecash ratiois just as it sounds, using cash orcash equivalentssuch asmarketable securitiesto measure liquidity. All othercurrent assetssuch asaccounts receivable, inventory, andprepaid expensesshould not be included in thecash ratiocalculation.

Because thecash ratiofocuses on cash and its equivalents, it can provide the most realistic results of any of theliquidity ratios.

How to calculate the cash ratio

Thecash ratiouses only cash and equivalents, dividing your cash totals by yourcurrent liabilities. The calculation is:

Cash Ratio= (Cash +Marketable Securities) / Liabilities

Acash ratiowill normally be lower than both the current or thequick ratiobecause the parameters are much narrower. Most businesses should strive for acash ratiobetween .5 and 1, although creditors may want to see it higher.

A good liquidity ratio can vary from industry to industry, making it important to always compare the results of your company to those of similar companies.

Differences between theliquidity ratios

While all of theliquidity ratiosare designed to measure how easily your business can pay offshort-termliabilitieswithcurrent assets, they all provide a different level of measurement.

Using the followingbalance sheet, we’ll calculate theCurrent Ratio, theQuick Ratio, and theCash Ratiofor JNB Manufacturing.

Current ratiocalculation

For example, in December of 2020, JNB’sbalance sheethad totalcurrent assetsof $307,000 and totalcurrent liabilitiesof $80,000. Because thecurrent ratiouses allcurrent assetsin the calculation, you can use the entirecurrent assetstotal to calculate thecurrent ratio.

$307,000 / $80,000 = 3.84

This shows that for every $1 that JNB has incurrent liabilities, they have $3.84 worth ofcurrent assets, giving them acurrent ratioof nearly 4.

Quick ratiocalculation

Thequick ratiocalculation includes onlyliquid assetssuch as cash andaccounts receivable, so you’ll need to include only JNB’s cash total,marketable securitiestotal, andaccounts receivabletotal found on thebalance sheet.

($125,000 + $30,000 + $31,000) / $80,000 = 2.32

When removingprepaid expensesand inventory, you’ll notice that JNBs liquidity drops from nearly a 4 to 1 ratio to a 2 to 1 ratio. The result above indicates that for every dollar in liabilities, JNB has $2.32 in assets.

Cash ratiocalculation

Used most frequently by creditors and financial institutions, thecash ratiois considered the most stringent of the threeliquidity ratios, using only cash andmarketable securitiesin its calculation.

($125,000 + $30,000) / $80,000 = 1.93

The result of 1.93 means that for every dollar in liabilities, JNB has $1.93 in assets.

Based on the above calculations, you can see that the results dropped from a high of 3.84 when calculating thecurrent ratioto a low of 1.93 for thecash ratio, depending on whatcurrent assetswere included in each of the calculations. A lowcash ratiocan also pinpoint an issue with companycash flow.

What is a goodliquidity ratio?

Calculatingliquidity ratiosis a fairly simple task. Butliquidityratioanalysiscan be more complicated for a variety of reasons. First, a goodliquidity ratiocan vary from industry to industry, making it important to always compare the results of your company to those of similar companies.

For example, the industry standard for thecurrent ratiousually falls between 1.2 and 2, with a higher result considered better. A goodcurrent ratiois 2, meaning that you have twice as much in assets that can pay off any liabilities due. A business with acurrent ratioof less than 1 indicates that your business may have difficulty paying anyshort-termfinancial obligations.

But higher isn’t always better. Too high of aliquidity ratiocan also be problematic; signifying possible issues with cash management.

For example, potential investors will likely view aliquidity ratiobetween 1 and 3 favorably. However, a ratio higher than 3 can raise a red flag with investors, who may view a company with ahigherliquidityratioas too cautious or unable to properly use its resources.

It’s important to remember that each industry will have its own standard. For example, a retail business that needs to stock large amounts of inventory will have a much differentliquidity ratiothan a service business.

As an example, let’s take a look atAmazon.com’sliquidity ratiosand what they mean. As of December 2020, Amazon.com had acurrent ratioof 1.05, meaning that it has equal amounts of bothshort-termassetsand liabilities. Theirquick ratiowas 0.83, while theircash ratiowas 0.67.

However, Amazon’s business model like Walmart and Target is based on inventory, which means a much higheraccounts payableliability total. Their business model does not typically offer credit to customers, eliminating anaccounts receivablebalance. Theircurrent ratioof 1.05 means that they have just about the same amount ofcurrent assetsas they havecurrent liabilities, while theirquick ratioandcash ratiosare a bit lower. But because of their inventory-heavy business model, these totals are actually within the range that they should be.

Liquidity vs. Profitability

With all this talk of liquidity, you might be wondering what the difference is between liquidity and profitability. To make things even more confusing, a company can be profitable but not liquid.

For example, considering Amazon’sliquidity ratios, when you look at theirprofit margin, you’ll see that their relatively low liquidity does not impact their profit margin. As of December 2020, theirprofitability ratiowas 39.57%. So, what is the difference between liquidity and profitability?

Profitability is theability of a companyto make a profit after all business expenses have been deducted from revenue earned. On the other hand, liquidity refers to acompany’s abilityto payshort-termdebtwith itscurrent assets. Companies like Amazon.com remain profitable even when liquidity is at a minimum since the majority of their assets are tied up in inventory. While profitability is more important for the long-term success of any business, liquidity is ashort-termmeasurement of a business’s ability to pay theshort-termdebtat any given time.

Should you calculateliquidity ratios?

Though primarily used by credit analysts and potential investors,liquidity ratioscan also provide usefulmetricsfor business owners and managers who want to check on their company’ssolvency. This is particularly important when applying for a loan or credit terms from a vendor since they will likely calculate the ratios themselves to determine the ability of your company to pay itsshort-termdebt.

Butfinancial ratioscan also provide you with some much-needed insight, offering insight into whether you’re able to meet currentfinancial obligationsincluding employee salaries, utility bills, rent, and taxes.

Easy to calculate and easy to analyze, there is no good reason not to calculateliquidity ratiosfor your business.