Investing for Beginners , investing

Liquidity ratio is a ratio that measures company’s liquidity. At first, it is needed to mention that liquidity may have two meanings: financial liquidity of a company or market liquidity of some asset. Liquidity ratios usually are applied to measure company’s financial liquidity which means short-term financial stability of a firm. Company’s liquidity and solvency represent different risks: solvency analysis relies on long-term performance of the company while even well performing companies may face liquidity problems during some periods if cash flow will be managed not properly enough. 

There are three main financial liquidity measurement ratios:

1. Current ratio is the main ratio to measure company’s liquidity. This ratio takes in to consideration all short-term assets from the balance sheet and compares those to current liabilities.

Current ratio = Current asset / Current liabilities

2. Quick ratio is very similar to the current ratio; the only difference is that inventory is excluded from current assets during the calculation because the cashing of inventory would be lower if sales would slowdown which makes them less liquid assets. This ratio is always lower than the current ratio.

 Quick ratio = (Current assets – Inventory) / Current liabilities

3. Cash ratio is quite different from those two that mentioned before. This ratio includes only cash and cash equivalents amid all the assets. Cash is the most liquid asset (of course if it is held in a safe place) but normally companies don’t have enough of cash to cover all current liabilities.

 Cash ratio = Cash / Current liabilities

When company’s financial liquidity is measured, all these ratios can be calculated and compared. While high cash ratio could indicate certain liquidity, companies that accumulate a lot of cash have other disadvantages. The main problem with ‘current ratio’ and ‘quick ratio’ is that book value of assets might be different from the real market value and only market value truly represents what those assets are worth. Yet, in practical calculations it is very difficult to determine real market value of those assets and values from balance sheets are used. 

High liquidity ratios mean that short-term stability of the company is solid. However, short term stability is not that much important as overall performance of the company. Sometimes happens, that company may face shortage of funding for working capital during financial crisis, but in reality, if company is very strong and have some lag in cash flow income, there should be no problem to find some financing during any period. Yet, if company is not very strong (high debt to EBITDA and low coverage ratios) then liquidity might be problem as well as some creditors might avoid financing risky companies during strong financial turmoil.

(To calculate liquidity ratio for a financial company ‘reserve ratio’ should be used.)