The health of a business can be measured in numerous ways, from pre-tax profit margin to accounts receivable turnover. To measure the immediate health of a business, however, you should look to how well a company is able to meet debt obligations.
This is reflected in liquidity ratios. Liquidity ratio in itself is not a metric, but rather a class of metrics. This includes current ratio, quick ratio and others. At their heart, they reflect whether a company is able to pay debt obligations with cash on hand.
Simply, it shows if a company can pay its bills without turning to outside credit. A company with a liquidity ratio of 1 or above is in good standing and able to meet current liabilities. Anything below 1 means the business will have issues paying debts.
Below, we’ll discuss liquidity ratios, how they’re calculated and why they’re important.
Importance of liquidity ratios
Liquidity ratios show the state of a business right now. They provide a valuable snapshot of the state of company for internal and external parties.
Provide insight into a company’s ability to cover short-term obligations
Liquidity ratios can immediately show if a company is financially secure or in danger of defaulting on debt obligations. High levels of liquidity show a company that is able to pay short-term debts.
Help creditors decide if they should loan money
It’s standard practice for potential creditors to examine a company’s liquidity before extending credit. Loan providers want to know if a business is able to meet the obligations of the debt. Low liquidity could mean higher interest rates or being rejected. A lack of available credit can limit a company’s growth or expansion potential.
Help investors determine if your company is worth investing in
Similar to creditors, potential investors use liquidity ratios during the investigation process. A low number is obviously alarming, but an abnormally high number can be concerning as well. Keeping significantly more cash on hand than is necessary means missed opportunities, leaning towards overly cautious. It may tell investors that a company is unsure of how to grow business or how to maximize available resources.
Types of liquidity ratios
There are three commonly used formulas to determine liquidity: current ratio, quick or acid test ratio and cash ratio. Each are valuable and serve a different purpose, but answer the same question.
Current ratio
Current ratio formula measures if a company can meet short-term debts with assets on hand. Current assets are considered to be assets that can quickly be turned into cash, like accounts receivable, short-term deposits and securities and, well, cash. An ideal ratio is around 1.2-1.5. It shows a company ready to pay current obligations, that is prepared for unanticipated market shifts and is not unnecessarily keeping assets on the sidelines.
Quick ratio / Acid test ratio
The quick ratio formula (sometimes called the acid test ratio) calculates how well a business can pay current debts with quick assets.
Quick assets are assets that can be turned into cash within 90 days. These may include accounts receivable, marketable securities or even inventory. A number under 1 means a company is in danger of being unable to meet immediate debt requirements. Too large of a number means a business may be leaning on a specific asset too much.
Cash ratio formula
Cash ratio calculates the ratio of cash (or an equivalent) to all liabilities. It shows how ready a business is to pay all liabilities. Cash ratio is of particular interest to creditors when evaluating a potential loan. It’s a measure of a company’s floor value. If something catastrophic happens, can the company still cover its liabilities. It answers the question, can a pay all debt immediately if required?
A ratio of 1 is desirable. It shows a responsible company that is mindful of debt, but doesn’t leave money wasting away in a bank account.
Liquidity ratio formulas and examples
We’ve discussed the value of liquidity ratios. Now we’ll show how they’re actually calculated.
Current ratio formula
Current Assets/Current Liabilities = Current ratio
Example: If you have assets of $1.2 million and liabilities of $1 million, your current ratio is 1.2
Quick ratio / Acid test ratio
(Cash and Cash Equivalents + Current Receivables + Short-Term Investments)/Current Liabilities
Example: If you have $1 million in cash, accounts receivable of $800,000 and $400,000 in short term investments and $2 million in liabilities, your quick ratio is 1.1
Cash ratio
(Cash + Equivalent)/Current Liabilities = Cash ratio
Example: If you have $5 million in cash on hand and liabilities of $4 million, your cash ratio is 1.25.
Increase your company’s liquidity ratios
We’ve established the value of a good liquidity ratio, but how do you get one? The easiest way to do that is to increase on-hand assets and one of the most effective ways to do that is to ensure that your customers are paying on time. Here, your accounts receivable operation takes on an added layer of importance.
Submitting early invoices will get the payment process started sooner and following up when needed will increase cash flow. It’s a simple step that can have significant impacts. A good liquidity ratio improves the bottom line, increases the value of a business and opens up more opportunities for growth.
An automated billing solution can do this for you. It takes all the stress of manually tracking customers and automates the process, removing complexity and meaningfully impacting a business.
