A key metric many investors use when evaluating the quality and fundamentals of a company prior to investing is the liquidity ratio. It’s a measurement investors use to gauge a company’s financial health and can be a useful tool for deciding which companies you may want to invest in.
But liquidity ratios don’t paint a complete picture of a company’s long-term chances of success — they illustrate only one facet of a company’s financial position.
Liquidity ratios are financial metrics that measure a company’s ability to pay down its short-term debt, usually within a year. Liquidity can be measured through several ratios, including the current ratio, the quick ratio and days sales outstanding (DSO).
In its simplest form, a company’s liquidity can be measured by dividing its liquid assets by its short-term liabilities, which you can find on the company’s balance sheet.
Liquidity ratio = Liquid assets / Short-term liabilities
A company that has high liquidity has enough liquid assets to meet its financial obligations. Liquid assets include cash on hand or assets that can easily be converted to cash.
A good liquidity ratio is anything greater than one. A liquidity ratio of one means that a company’s liabilities don’t exceed its assets and it can meet its current financial obligations. While a company with high liquidity is generally viewed as being in a strong financial position, too high liquidity can mean a company is holding too much cash that could be utilized in other areas.
But a company with low liquidity might be seen as a red flag. If cash is tied up and the company is having trouble meeting its short-term debt obligations, the company is at a higher risk of bankruptcy.
So, low liquidity ratios can be a good indication that a company is struggling to stay in business or to grow. A low liquidity ratio would be anything under 1.
A financial metric used to determine a company’s ability to repay its current debt obligations without raising external capital.
Liquidity ratios reveal several insights about a company and can be used to:
Liquidity ratio analyses should be looked at within the proper context, and this analysis can be internal or external.
Internal analysis examines a company’s internal factors to assess its resources, assets and capabilities. Internal analysis regarding liquidity ratios might compare a company’s current financial position against previous accounting periods. This allows an investor to see whether a company’s financial position is improving or worsening.
Investors should also compare a company’s liquidity ratios with those of its competitors, sector or even its entire industry. This can give an investor an idea of which companies may be in a stronger financial position.
Much like internal analyses, ratios during external analyses should be compared over several years. Companies in comparison should also be similar in nature. Liquidity ratio comparison can be less effective when comparing businesses of different sizes or across industries.
A company’s liquidity ratio can be calculated several ways, but the most common variations of the ratio are:
The current ratio is the simplest version and most common way of measuring a company’s liquidity. The current ratio considers a company’s total current assets against its total current liabilities. It looks only at assets that are convertible to cash in less than a year and debts that are due within a year.
The current ratio formula is:
Current ratio = Current assets / Current liabilities
The quick ratio, also known as the acid-test ratio, measures a company’s ability to repay its short-term debt with its most liquid assets and is a tougher, more stringent liquidity test. It eliminates specific current assets, such as inventory and prepaid expenses, because they can’t be quickly converted into cash. The quick ratio is a more conservative metric than the current ratio and only looks at cash, short-term investments and accounts receivable.
The two quick ratio formulas are:
Quick ratio = (Cash and equivalents + Short-term investments + Accounts receivable) / Current liabilities
Quick ratio = (Current assets – Inventories – Prepaid expenses) / Current liabilities
Both formulas are equivalent. But if the company’s financial statement doesn’t break down its quick assets on its balance sheet, you can use the second formula instead.
DSO is a measure of how quickly credit sales are converted into cash and how long it takes a company to collect its accounts receivable. DSO is considered an important tool in measuring a company’s liquidity. A low DSO value reflects high liquidity and indicates a company is getting its payments quickly.
The DSO formula is:
DSO = Accounts receivable during a given period / Net credit sales X Number of days in the period being measured
A liquidity crisis refers to a financial situation where cash is drying up and the company lacks the money to repay its debts. Thus, the company is in a situation of default. Companies in this situation might panic-sell their assets at steep losses to generate enough cash to avoid bankruptcy.
Solvency is a long-term measure, and it helps assess a company’s ability to survive financially over a long period. Whereas liquidity ratios help determine a company’s ability to meet its short-term obligations, solvency ratios measure a company’s financial health by considering its ability to meet its total financial obligations, including its long-term debt. Together, liquidity and solvency ratios can provide a clear picture of a company’s financial well-being.
The solvency ratio formula is:
Solvency ratio = (Net income + Depreciation) / All liabilities (Short-term + Long-term liabilities)
To understand how liquidity ratios work, look at the following balance sheet mockup of two hypothetical companies, Company A and Company B. We assume both companies are competitors in the same industry.
| Balance sheet (in millions) | Company A | Company B |
|---|---|---|
| Cash | $10 | $1 |
| Marketable securities | $10 | $2 |
| Accounts receivable | $20 | $2 |
| Inventories | $20 | $5 |
| Current assets (a) | $60 | $10 |
| Plant + equipment (b) | $40 | $45 |
| Intangible assets (c) | $30 | $0 |
| Total assets (a+b+c) | $130 | $55 |
| Current liabilities (d) | $20 | $40 |
| Long-term debt (e) | $80 | $10 |
| Total liabilities (d+e) | $100 | $50 |
| Shareholders’ equity | $30 | $5 |
Comparing the two companies, Company A has enough liquid assets to cover its current liabilities three times over and thus has high liquidity. Using the more stringent quick ratio where inventories are removed, Company A still has sufficient liquidity with the ability to cover its current liabilities twice.
Company B has a current ratio of 0.25, which may suggest that the company has insufficient liquidity. With only 0.25 of assets, it doesn’t have enough liquidity to cover its current liabilities. Apply the stricter quick ratio and you see that the company has an alarmingly low degree of liquidity.
Liquidity ratios are financial metrics that give investors a snapshot of a company’s financial position, particularly a company’s ability to pay down its short-term debt. A company with a liquidity ratio of at least 1 shows that it’s in a position to meet its current financial obligations. A higher liquidity ratio indicates a stronger financial position, whereas a lower liquidity ratio can potentially mean a company has insufficient liquidity.
Whether investing in corporate bonds or trading stocks, liquidity ratios can be insightful tools for investors.
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