Liquidity is the ease with which one can convert their assets into cash for quick use. One can determine an asset’s liquidity by considering how easily and quickly it can be exchanged, as well as whether it can be exchanged for little to no cost. Assets such as cash/currency, funds in a deposit account, stocks, bonds, and currency can all be considered liquid assets. A business or person generally considers themselves financially liquid if they have more savings than debt. To determine a business’s liquidity, businesses traditionally use one of these three ratios: current ratio, quick ratio, and cash ratio.
What Liquidity Ratios Tell You
A liquidity ratio can help investors decide whether to invest in stocks or buy corporate bonds. A high ratio may indicate that the business has a strong financial background to pay their debt, and a low ratio may indicate the business is likely to default on debts.
Current Ratio measures a business’s ability to pay short-term obligations. The formula for computing this amount is current assets / current liabilities. This calculation allows investors to see how a business can maximize their current assets on their balance sheet. The company will list cash, accounts receivable, inventory, and other current assets on this balance sheet, which can be converted into cash within the next year. For the current liabilities, this will include a business’s accounts payable, wages, taxes, short-term debts, and some long-term debts. A current ratio may change over time, but ideally the higher the current ratio, the more efficiently a business will be able to pay their obligations.
Quick Ratio, also known as an Acid Test Ratio, is calculated by dividing the sum of a business’s liquid assets by their current liabilities. The difference between quick ratio and current ratio is that quick ratio only includes assets that can be turned into cash within 90 days or less. Furthermore, current ratio calculates all a company’s assets, while quick ratio only uses liquid assets in calculation. The formula is essentially the same as quick ratio, equaling quick assets/current liabilities. Quick assets may include a business’s accounts receivable, cash, cash equivalents, and marketable securities.
A cash ratio only compares cash to current liabilities to calculate if a business can meet their financial obligations just through cash and not needing to sell their other assets. The formula for cash ratio are cash/current liabilities with coins, currency, checks, bank drafts, or checking accounts being designated as cash. This ratio is stricter than other liquidity metrics because it measures only cash equivalents.
Is it Possible To Improve Liquidity Ratios?
Some operational changes can improve liquidity ratios for a business that is experiencing low liquidity. A business owner can try to reduce or control overhead expenses, revisit debt obligations, sell unnecessary assets, etc. Scheduled and consistent review of a business’ financial health will be the best way to discover where and how to save time and money. In turn, improve the business’ liquidity ratio.
Why is Liquidity Important?
Liquidity is important because the markets are not always liquid, and it can become difficult to sell assets and/or securities. Instead of losing money, one can easily sell liquid assets for their full value. Or not being able to sell an asset if there is no market for it. If a business does not hold enough liquid assets, they may not be able to cover short-term obligations. In a worst-case scenario – end up filing for bankruptcy.