Analysing your liquidity ratio is essential, especially when determining your financial metric covering short-term obligations, creditworthiness, or investment worthiness. With that in mind, here is a helpful guide that will help you understand and analyse liquidity ratios quickly.
But before that, let’s go back and define what a liquidity ratio is first. Liquidity ratios are defined as the means to determine the credibility of a company and its ability to pay back debts accordingly on their short-term due dates. Now, here are the three types of liquidity ratios to remember, which include the following:
- Cash Ratio: It is also known as the Cash Asset Ratio. This ratio is the simplest to compute and can be calculated by dividing your cash and equivalent assets by your current liabilities. These existing assets include your stock, debtor, cash and bank, receivables, loan and advances, to name a few. On the other hand, your current liabilities would be things such as your creditor, short-term loan, bank overdraft, and outstanding expenses.
- Quick Ratio: This ratio is also referred to as the Acid Test Ratio. This ratio considers certain assets, like your accounts receivable along with the cash divided by the current liabilities.
- Current Ratio: This ratio compares your company’s current assets to your current liabilities.
Now that we’ve finished our quick refresher about liquidity ratios let us tackle the 3 things to consider when analysing liquidity ratios.
Maintaining one or Higher Ratio
According to the Corporate Finance Institute, the good or the ideal liquidity ratio is equal to or higher than 1. By getting an exact ratio of 1, your company is determined to have the ability to pay all current liabilities using your existing assets. A liquidity ratio greater than 1 means that your company has greater means to cover your current liabilities. To be more specific, let’s say you get a computed ratio of 2. This means that your company has 2 times the greater ability to cover all your liabilities.
However, if your computed liquidity ratio is less than 1, it means that your company will be unable to pay off your current liabilities. Therefore, getting a ratio lower than the ideal ratio will get your company disapproved when applying for credit.
However, a higher ratio doesn’t necessarily always mean good news for your company. This is because a higher ratio could also indicate that cash resources are not being utilised properly by a company since you are not adequately distributing or allocating these cash resources on your capital.
Keep in Mind the Long-Term Liabilities that Soon Turn Short-Term
Depending on different factors, your liquidity ratio analysis results may vary. In other circumstances, it may lead to misleading results as well. So, for instance, your liquidity ratio may be affected by the timing. An example of this is “cash inflow or outflow that falls just outside of the requirements of a ratio.” These are the things that may not be classified as a current liability in your company as of now.
Look at Historical Liquidity Ratios
Another factor you should consider is the seasonal influences that can impact your liquidity ratio analysis. Again, this is needed, especially when these changes significantly influence a target entity. For instance, the information based on these ratios found in your balance sheet, which includes your company’s financial situation and health details, might differ in a few months.
By regularly analysing your company’s liquidity ratios, you can keep track of your company’s financial situation, generate helpful insight that you can use to your benefit, and watch out for your company’s financial health as well.
More importantly, your final computed liquidity ratio should not be taken as it is. It would be best to consider looking at it from another perspective, as it may not give you everything you need to know. For instance, varying liquidity ratio computations could indicate financial instability, which is not a good sign for your company’s financial health. And as previously mentioned, higher liquidity ratios could also mean improperly utilised cash resources.
Finally, it is essential to conduct much more detailed analyses of all your assets and liabilities. This is to avoid yielding misleading results. This can be done by paying extra attention to specific receivables that can skew the computation of your liquidity ratios.