What are ‘Liquidity Ratios’
Liquidity ratios measure a company’s ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio and operating cash flow ratio. Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency. Bankruptcy analysts and mortgage originators use liquidity ratios to evaluate going concern issues, as liquidity measurement ratios indicate cash flow positioning.
BREAKING DOWN ‘Liquidity Ratios’
Liquidity ratios are most useful when they are used in comparative form. This analysis may be performed internally or externally. For example, internal analysis regarding liquidity ratios involves utilizing multiple accounting periods that are reported using the same accounting methods. Comparing previous time periods to current operations allows analysts to track changes in the business. In general, a higher liquidity ratio indicates that a company is more liquid and has better coverage of outstanding debts.
Alternatively, external analysis involves comparing the liquidity ratios of one company to another company or entire industry. This information is useful to compare the company’s strategic positioning in relation to its competitors when establishing benchmark goals. Liquidity ratio analysis may not be as effective when looking across industries, as various businesses require different financing structures. Liquidity ratio analysis is less effective for comparing businesses of different sizes in different geographical locations.
Solvency Versus Liquidity
Solvency relates to a company’s overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current financial accounts. A company must have more total assets than total liabilities to be considered solvent and more current assets than current liabilities to be considered liquid. Although solvency is not directly correlated to liquidity, liquidity ratios present a preliminary expectation regarding the solvency of a company.
Examples of Liquidity Ratios
The most basic liquidity ratio or metric is the calculation of working capital. Working capital is the difference between current assets and current liabilities. If a business has a positive working capital, this indicates it has more current assets than current liabilities and in the event of an emergency, the business can pay all of its short-term debts. A negative working capital indicates that a company is illiquid.
The current ratio divides total current assets by total current liabilities. This ratio provides the most basic analysis regarding the coverage level of current debts by current assets. The quick ratio expands on the current ratio by only including cash, marketable securities and accounts receivable in the numerator. The quick ratio reflects the potential difficulty in selling inventory or prepaid assets in the result of an emergency.