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Liquidity Ratio: Definition, Uses, Types, and Importance
What is Liquidity Ratio?
The ratio which measures the capability of a firm to meet its current obligation is known as liquidity ratio. This ratio derived its name from ‘liquidity’ referring to ‘the cash deposits available’.
As a result, liquidity ratios are helpful in determining the firm’s ability to meet its short- and long-term liquidity needs. Liquidity ratios form a relationship between cash and other forms of assets to show the firm’s ability to meet its current obligations (current liabilities).
Uses of Liquidity Ratio
Liquidity ratios are used to measure the liquidity position of a company. Usually, high equity is considered to be good for the firm because it can meet the current obligations if it has a high equity reservoir.
However, it is also true that too much liquidity is detrimental to the firm. Therefore, firms should have an ideal balance of equity and debt. As liquidity ratios show the current mix of equity and debt, managers, owners, and investors can understand the true form of the health of the company and take necessary actions as deemed suitable.
Types of Liquidity Ratios
The most popular types of liquidity ratios that show the extent of liquidity of a firm are the Current Ratio and the Quick Ratio.
Current Ratio
Current ratio is given by current assets divided by current liabilities. The current Ratio includes current assets and liabilities that can be determined within a year. The current assets include market-ready securities, inventories, debtors, and prepaid expenses. Obligations that should be met within a year, such as short-term bank loans, creditors, bills payable, accrued expenses, and income tax liabilities.
Quick Ratio
Quick ratio forms a relationship between quick assets and current liabilities. Quick assets include items that can be converted to cash within a short span of time or immediately without losing any value. Quick assets are obtained by subtracting inventories from current assets. The quick ratio is then measured by dividing quick assets by current liabilities.
$$\mathrm{Quick \:Ratio\:=\:\frac{Current\:Assets\:-\:Inventories}{Current\:Liabilities}}$$
Cash is considered to be the most liquid asset. Other assets that are considered to be quick are debtors, and bills receivable. Marketable securities are also considered to be liquid. However, inventories are considered non-liquid because it takes enough time to realize as cash and their value fluctuates from time to time.
Other types of liquidity ratios which are in use are Cash Ratio, Interval Measure, and Net Working-Capital Ratio.
Cash Ratio
Sometimes, it may be useful to examine the cash position of a company for which cash ratio is useful. Cash is also the best form of liquidity, so the cash ratio offers an insight into the cash position of a company. The ratio is obtained by dividing cash items by current liabilities.
$$\mathrm{Cash\:Ratio\:=\:\frac{Cash\:+\:Marketable\:Securites}{Current\:Liabilities}}$$
Having a smaller amount of cash is not a matter of concern if a firm has a reserve of borrowings. However, it should be able to repay the borrowed funds in time.
Interval Measure
Interval measure examines the capability of the firm to meet its regular needs on a day to day basis. It connects liquid assets to average daily operating cash outflows. To measure average daily expenses, the cost of goods sold and selling figures are added. Depreciation and daily administrative expenses are subtracted and the obtained amount is divided by the number of days in a year (360).
$$\mathrm{Intervl\:measure\:=\:\frac{Current\:Assets\:-\:Invetories}{Avg.Dailt\:Operating\:Expenses}}$$
Net Working Capital Ratio
The net working capital ratio is the ratio between net working capital and net assets. The gap between current assets and current liabilities excluding bank borrowing is called Net Working Capital (NWC). The NWC measures the potential reservoir of funds and can be connected to net assets (NA).
$$\mathrm{Net\:Working\:Capital Ratio\:=\:\frac{Net\:Working \:Capital}{Net\: Assets}}$$
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