What is a liquidity ratio?
A liquidity ratio is a financial ratio used in accounting[i] to evaluate a business’s ability to pay its short-term debt obligations, also called current liabilities, with its current assets.
Types of liquidity ratios
Liquidity ratios comprise the following ratios:
- Current ratio/Working capital ratio
- Quick ratio/Acid test ratio
- Cash ratio
- Operating cash flow ratio
Current ratio
What the current ratio measures
The current ratio measures a business’s ability to pay off its short-term liabilities with its current assets.
The ratio can also be classified under the activity ratios as the working capital ratio.
- Short-term liabilities
Short-term liabilities, also called current liabilities, are debt obligations that need to be paid within one year. Current liabilities are reported on the balance sheet of a business.
Examples of short-term liabilities:
- Accrued expenses
- Accounts payable (Also referred to as payables)
- Short-term loans
- Bank account overdrafts
- Interest payable
- Income taxes payable
- Dividends payable
- Customer deposits
- Current portion of long-term debts
- Current assets
Current assets, also called current accounts or liquid assets, are cash and other assets of a business that are expected to be converted to cash within one year. Current assets are reported on a company’s balance sheet.
Examples of current assets:
- Cash and cash equivalents, such as money market instruments
- Inventory
- Accounts receivable (Also called receivables)
- Prepaid expenses
- Short-term investments
- Marketable securities
- Formula
Current ratio = Current Assets/Current liabilities
- Example of the current ratio
If company Picture Perfect’s current assets are R1 200 000 and its current liabilities are R400 000, its current ratio will look as follows:
R1 200 000/R400 000
= 3:1
Thus, the company will be able to pay off its short-term debt obligations 3 times with its current assets available.
The higher the current ratio, the better a business’s liquidity position, and vice versa.
Quick ratio
What the quick ratio indicates
The quick ratio, also known as the acid test ratio, indicates whether a business can satisfy its current liabilities with its most liquid current assets such as cash, cash equivalents, accounts receivable, and short-term marketable securities.
Put differently, the quick ratio excludes less liquid current assets like inventory and prepaid expenses, making it a stricter test of a business’s liquidity than the current ratio.
- Formula
Quick ratio = (Current assets – Inventory – Prepaid expenses)/Current liabilities
- Example of the quick ratio
Let us take company Picture Perfect with its R1 200 000 current assets and R400 000 current liabilities again as an example.
Included in the current assets are an inventory of R350 000 and prepaid expenses of R50 000.
Company Picture Perfect’s quick ratio will no be calculated in the following way:
Quick ratio = (R 1 200 000 – R350 000 – R50 000)/R400 000
= R800 000/R400 000
= 2:1
The company’s current ratio is 3:1. However, the quick ratio of 2:1, which is the stricter liquidity test of the two ratios, shows that the company will only be able to pay off its current liabilities 2 times (and not 3 times) with its current assets available.
Cash ratio
What the cash ratio shows
The cash ratio, also referred to as the cash asset ratio, only takes a business’s most liquid current assets, namely cash and cash equivalents, into consideration when it determines whether a business will be able to pay off its current liabilities.
Cash equivalents include liquid assets like money market instruments and marketable securities.
The cash ratio is the most conservative and strict ratio of the three ratios (current ratio, quick ratio, and cash ratio).
- Formula
(Cash + Cash equivalents)/Current liabilities
- Example of the cash ratio
Company Picture Perfect is again taken as an example to demonstrate the differences between the three liquidity ratios.
As already mentioned, the company has R400 000 current liabilities on its books. Included in its current assets of R1 200 000 are cash of R250 000 and cash equivalents of R150 000.
Picture Perfect’s cash ratio will look as follows:
(R250 000 + R150 000)/R400 000
= R400 000/R400 000
= 1:1
Thus, the cash ratio shows that the company will only just manage to pay off its short-term debt obligations.
Operating cash flow (OCF) ratio
What the OCF ratio determines
The operating cash flow (OCF) ratio is a liquidity ratio that determines how efficiently a business can pay off its current liabilities with the amount of cash generated by its normal business operations.
Express, in other words, the OCF ratio indicates how much a business earns from its operating activities per rand (ZAR) or US dollar of its current liabilities during a specific accounting period such as a quarter or a year.
A business’s cash flow from operations can be found on its statement of cash flows.
- Formula
Operating cash flow ratio = Operating cash flow/Current liabilities
- Example of the operating cash flow ratio
The following information was obtained from company BBB’s annual financial statements:
- Operating cash flow: R750 000
- Current liabilities: R600 000
Calculation of BBB’s operating cash flow ratio:
R750 000/R600 000
= 1.25
Hence, company BBB will be able to cover its current liabilities 1.25 times with the cash generated from its operating activities. Put differently, the company earns R1.25 from its operating activities, per rand (ZAR) of its current liabilities.
Why are liquidity ratios important?
Liquidity ratios are important financial tools in accounting.[ii] The ratios are useful for:
- Creditors, such as suppliers, to determine if a business can cover its short-term debt obligations.
- Lenders when deciding whether they should extend credit to a business.
Investors when analysing a company’s ‘investment worthiness’, ensuring that a company is financially healthy.
[i] Refer to the article, ‘Accounting Ratios Explained for Dummies’, for an overview of the numerous ratios used in accounting.
[ii] See the article, ‘Accounting Explained for Dummies’, for more information about accounting in general.
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