What Is a Liquidity Ratio?
A liquidity ratio is a measurement of a company’s ability to pay off its current debts with its current assets.
There are various types of liquidity ratios, including the current ratio and the quick ratio. Usually, a liquidity ratio greater than 1 is a positive sign. But a very high liquidity ratio isn’t necessarily a good thing.
Companies can increase their liquidity ratios quickly in a few different ways, including using sweep accounts, cutting overhead expenses, and paying off liabilities.
Read on to learn more about liquidity ratios and how a company can increase them.
Key Takeaways
- Ways in which a company can increase its liquidity ratios include paying off liabilities, using long-term financing, optimally managing receivables and payables, and cutting back on certain costs.
- Liquidity ratios measure the ability of a company to pay off its short-term obligations with its current assets.
- Two of the most common liquidity ratios are the current ratio and the quick ratio.
- A higher liquidity ratio indicates a company is in a better position to meet its obligations, but can also indicate that a company isn’t using its assets efficiently.
- A satisfactory ratio can differ depending on the ratio type.
Understanding Liquidity Ratios
A company calculates a liquidity ratio by dividing its current assets by its short-term liabilities.
A liquidity ratio can be a valuable metric for market analysts and potential investors. That’s because it can help them to determine if a company is financially healthy enough to pay off its short-term debts and other current liabilities.
A low liquidity ratio could signal a company that is in financial trouble. However, a very high liquidity ratio may show that a company is too focused on liquidity, to the detriment of efficiently utilizing its capital to grow and expand its business.
The Current and Quick Ratios
As mentioned above, two commonly reviewed liquidity ratios are the current ratio and the quick ratio.
Current Ratio
The current ratio provides a good indication of a company’s ability to cover its short-term liabilities. It’s a measure of all current assets that can be turned into cash quickly and used to pay all short-term obligations.
For this ratio, current assets include cash, cash equivalents, inventory, marketable securities, and certain other short-term investments.
Quick Ratio
The quick ratio refines the current ratio, measuring the most liquid assets a company has to cover liabilities, including cash, receivables, and marketable securities.
As a result, it is more conservative than the current ratio because it excludes inventory and some other current assets from the calculation.
As you might imagine, liquidity ratios can differ somewhat depending on which assets are used in the ratio formula.
Important
Creditors analyze liquidity ratios when deciding whether or not to extend credit to a company.
Increasing Liquidity Ratios
- One way to quickly improve a company’s liquidity ratio is to use sweep accounts that transfer funds into higher interest rate accounts when they’re not needed, and back to readily accessible accounts when necessary.
- Paying off liabilities also quickly improves the liquidity ratio. So does cutting back on short-term overhead expenses such as rent, labor, and marketing.
- A company can also increase its liquidity ratio by using long-term rather than short-term financing to acquire inventory or finance projects. Removing short-term debt from the balance sheet allows a company to save some liquidity in the near term and put it to better use.
- To increase a company’s liquidity ratio for the long term, take a look at accounts receivable and payable. Ensure that you’re invoicing customers as quickly as possible, and that they’re paying on time. When it comes to accounts payable, you’ll want to ensure the opposite—longer pay cycles are more beneficial to a company that’s trying to improve its liquidity ratio. You can often negotiate longer payment terms with certain vendors.
Why Do Liquidity Ratios Matter?
They matter because they give management and potential investors a way to gauge how easily and quickly a company could meet its short-term obligations, and without having to borrow money to do so. It’s a sign of a company’s short-term financial health. A company with solid liquidity, as demonstrated by liquidity ratios, should be able to weather periods when the economy weakens. It may also use some quickly available cash to take advantage of opportunities for growth.
When Is a Liquidity Ratio Too High?
It’s not an exact science, but a ratio that’s way above 1, for example 4, means that a company has enough in current assets to pay off its immediate obligations four times over. Some companies may feel that one time over is enough. In that case, it may be that cash isn’t being used properly and opportunities to grow value are missed.
How Do Liquidity Ratios Clarify a Company’s Potential for Default?
The more easily that a company can pay all of its short-term liabilities, the less chance there is that the company will default on them. Measuring how quickly current assets can be sold and the cash used to pay all of these bills is the role of liquidity ratios. By presenting a metric, such ratios demonstrate whether there’s a risk of default. A liquidity ratio of 1 indicates that all short-term debts can be covered by current assets.
The Bottom Line
Liquidity ratios, which measure a firm’s capacity to pay its short-term financial obligations with current assets, can be increased by paying off some liabilities, reducing costs, using long-term financing, and efficiently managing receivables and payables.
That said, a liquidity ratio that’s overly high does not always indicate stronger financial health, as it could mean that a company is not using its assets effectively to grow the value of the business.
