Liquidity Ratio and Its Types

When it comes to investing in a company, liquidity is a crucial aspect. Liquidity ratio is an essential tool to determine liquidity position of a company.

Read on for a breakdown of what liquidity ratios are, why are they important, various types of profitability ratio, how to calculate them and how to interpret liquidity ratios.

 

What are liquidity ratios?

Liquidity ratios is a type of financial used to determine a debtor's ability to pay off current debt obligations without raising external capital. It is used to determine a company’s ability to pay its short-term debt obligations. The metric helps determine if a company can use its current, or liquid, assets to cover its current liabilities.

 

Why are liquidity ratios important?

The liquidity ratio is a great ratio that quickly gauges the current financial health and well-being of a company. It can also give us a reflection of how well a company’s administration is managing working capital. It affects the credibility of the company as well as the credit rating of the company. If there are continuous defaults in repayment of a short-term liabilities, then this will lead to bankruptcy. Hence this ratio plays important role in the financial stability of any company and credit ratings.

 

Types of Liquidity Ratios

There are three types of commonly used liquidity ratios namely current, liquid and cash ratio.  In each of these ratios, current liability is placed in denominator and respective current assets are placed in numerator.

 

Current Ratio

Current ratios indicate the ability of the company to satisfy its current obligations using its current assets. Here, current assets include cash and cash equivalent, marketable securities, receivables, inventory, prepaid expense etc. and current liabilities includes short term debt obligations, creditors, payroll liability, outstanding expense etc.

 

Current ratios of more than 1 indicates that current assets are sufficient to cover current liabilities and current ratio of less than 1 indicates that the company is struggling to pay its debt. Theoretically, current ratio of 2:1 is considered good but anything above 1:1 is satisfactory.

 

Quick Ratio

Quick ratio is also known as acid test ratio. It is a stricter test of liquidity than the current ratio. It indicates company’s ability to pay its short-term obligations with its most liquid assets. Inventory cannot be quickly converted into cash and cannot be used to pay current liabilities immediately. Similarly, prepaid expense cannot be used to pay off current liabilities. So, inventory and prepaid expenses not included in the calculation of quick ratio.

 

Quick ratio of 1 and above indicates that the company is fully equipped to pay its current liability by instantly liquidating its current asset. As a result, quick ratio of 1 is considered good.

 

Cash Ratio

The cash ratio takes the test of liquidity even further. This ratio only considers a company’s most liquid assets – cash and marketable securities.  These are the only current assets of the company that are readily available to pay off current obligations.  This ratio indicates how quickly, and to what limit a company can repay its current dues with the help of its readily available assets.

 

Cash ratio of 1 and above indicates that the company can pay its current liability by using its most liquid assets. A ratio of less than 1, is not a bad sign as this only considers cash and marketable securities. Although, there is no standard cash ratio, a ratio between 0.5 and 1 is preferable.

 

Example of Liquidity Ratio

Current Ratio = 11917/8035

                        = 1.48

Quick Ratio = (11917-8300-38)/8035

                     = 0.45

Cash Ratio = (2188+65)/8035

                    = 0.28

 

Interpretation of Liquidity Ratio

Theoretically, the higher the ratio, the better a company's liquidity and financial health; the lower the ratio, the more likely the company will struggle paying it's debt. Thus, a company with higher liquidity ratio will be more attractive from an investment perspective. But there is a catch.

Why are high liquidity ratios not necessarily good

To understand this, lets breakup the components of current assets. When current ratio is 2, it means that company can current assets to pay off its current obligation twice. This high current ratio may be either due to high inventory, high receivable, or high cash reserves. High inventory can be due to unwanted piling up of slow-moving goods or weak sales. It may face risk of obsolescence. If a company has high receivable, it may indicate poor credit control measures and such companies can face risk of huge bad debt. If a company has high cash reserves, then it is probably losing out an opportunity to invest it and earn some returns on it. Each of these cases are not preferable.

 The curious case of Arvind Mills

Back in 1990s, Arvind Mills expanded rapidly in denim jeans segment.  In 1995, its current ratio was 6:1. This was mainly due to inventory pilling up as other Asian countries manufactured low cost denims. In 1998, it found itself in a situation where debt was rising, inventory was pilling up and downturn in demand of denims. The result was that Arvind Mills was almost close to bankruptcy. Of course, the company did a remarkable recovery from there.

 

What is Warren Buffet Take On This

Warren Buffet in his book “Warren Buffet and Interpretation of Financial Statements” states that some companies having durable competitive advantage of have a current ratio of less than 1. For example, Warren Buffet’s favourite Coco-Cola have a long history of current ratio close to 1 or less than 1. Such companies have immense earnings power and pay their current obligation through current earnings. In short, there are many companies with durable competitive advantage that have current ratio of less than 1. Such companies create a anomaly that renders the current ratio is useless in assessing durable competitive advantage of a company.

Final Words:

Liquidity ratio helps to asses financial health to company by assessing its ability to pay its current obligations through current assets. Remember, liquidity ratios are not the only ratios that you should track. Look for profitability ratios, turnover ratios, valuation ratios and solvency ratios as well and do your exhaustive research  before investing.

Happy Investing!