Every organization has some level of cash requirement for keeping its operations functional. Companies that are able to meet its cash requirement from a source with minimum cost, would maximize value for shareholders. Hence, the level of cash and liquidity of assets are very crucial to the survival of any organization. Liquidity is how easily an asset can be converted into cash.
Liquidity ratios give an idea about company’s ability to convert its assets into cash and pay its current liabilities with that cash whenever required. In simple language, they indicate the company’s ability to pay its short-term obligations whenever they are payable. Liquidity ratios focus on short-term survival of the company, while solvency focuses on long-term survival.
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TYPES OF LIQUIDITY RATIOS
FORMULA FOR LIQUIDITY RATIOS
It is found by dividing current assets by current liabilities. It shows whether current assets are enough to cover the current liabilities.
|=|| Current assets
Quick Ratio/ Acid Test Ratio
It is similar to the current ratio. However, in current assets, illiquid assets like inventory are not considered. Inventory can only be liquidated when there are buyers for the same. In the economic downturn or emergency situations, it will be difficult to sell inventory.
|=|| Quick Current Assets
|Quick Current liabilities|
Cash ratio only includes cash and cash equivalents in the numerators. Cash and cash equivalents include cash and marketable securities.
|Cash Ratio||=|| Total Cash and Cash Equivalents
Defensive Interval Ratio
Defensive interval ratio can be found by dividing liquid assets with estimated daily cash requirement. The daily cash requirement can be estimated from the past patterns of cash requirements. This ratio gives an idea whether liquid assets are enough to cover the daily cash requirements.
|=|| Liquid Assets
|Estimated Daily Cash Requirements|
USES OF LIQUIDITY RATIOS
Liquidity ratios are very useful for analyzing liquidity position of the company. These ratios are used externally as well as internally for analysis. Analysts compare the liquidity ratios of one firm to another firm or the industry for comparative analysis. They are very useful to short-term creditors or lenders. Creditors have lent some amount to the company and they would want to know whether the company will be able to pay that back in time or not. Also, they are used internally by the company itself to compare its liquidity position with the previous year. It gives an idea about changes in liquidity position of the company.
All the comparative analysis will less reliable if companies are of different industry, location or size. It should be used to compare companies of same nature.
- Financial Management by Ravi M Kishore, 6th Edition