What are the financial liquidity ratios?

What are the financial liquidity ratios?

Financial liquidity ratios indicate a company’s ability to meet obligations that are approaching maturity in the short term. If a company is taking out loans for a short period or some large bills need to be paid soon, the analyst will want to make sure that they can dip into the cash when they need it. The company’s banks and suppliers also need to keep an eye on the liquidity of the company, they know that illiquid companies are more likely to fail and default on their debts.

What is liquidity?

Sepúlveda ( p.120 ) defines liquidity as the ease with which an asset can be transformed into money. Liquidity depends on two factors: the time required to convert the asset into money and the certainty of not incurring losses when carrying out the transformation, therefore, money is the most liquid of all goods.

According to Durán ( p.164 ), liquidity is understood as the ease with which an asset can be transformed into money without suffering a significant loss of value. It is generally determined by the nature of the market where it is traded. Thus, the most liquid of assets is, logically, currency or paper money. The shares of a company can be more or less liquid depending on the average volume of business and the free float of the company (proportion of the company’s capital that is freely quoted on the market), although it is generally understood that they are quite liquid titles since they are listed on an organized market (the Stock Markets), where they can be bought and sold with relative ease. On the contrary, a property would be a clear example of illiquid value, since its sale requires considerable time and some mandatory legal formalities. The term can also be applied to an institution or an individual. Thus, it is understood that a company is liquid if a large part of its assets is in the form of cash or if they can be quickly converted into cash. This conception of liquidity offers an indication of the company’s ability to meet its short-term commitments.

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Liquidity ratios

Liquidity ratios give early signs of impending cash flow problems and business failures because a common precursor to financial trouble and bankruptcy is low or declining liquidity. Of course, a company should be able to pay its bills, so having sufficient liquidity for day-to-day operations is very important. However, liquid assets, such as cash held at banks and marketable securities, do not have a particularly high rate of return, so shareholders may not want the company to overinvestin liquidity. Companies have to balance the need for security that liquidity provides against the low returns that liquid assets generate for investors.

The following basic measures of liquidity are commonly used in financial analysis:

Liquidity ratio, or current

The liquidity ratio, or current, measures the company’s ability to meet its short-term obligations. Indicates how many dollars, pesos, or soles receivable in the short term the company has, for each dollar, peso, or sole to be paid in the short term. This financial ratio does not provide evidence of when those monies to be collected will enter or when the monies to be paid will be due. Like some other financial indicators, the liquidity ratio seen in isolation is not very relevant, but when combined with other ratios, when comparing it against companies in the sector, and when observing its evolution over time, it does yield interesting information for the analyst.

It is calculated by dividing the current assets (current) of the company by its current liabilities (current), the minimum that is generally considered acceptable is 2 to 1, although it may vary depending on the industry or economic sector of the firm.

See also  Working capital, profitability, leverage, liquidity, capital structure, bonds, and shares

 

Quick Ratio = Quick Current Assets / Quick Current Liabilities

Current assets include money a business has on hand and in the bank, plus any assets that can be converted to cash within the “normal” twelve-month operating period, such as marketable securities held as short-term investments. term, accounts receivable, inventories, and advance payments. Current liabilities include any financial obligation that falls due within the following year, such as accounts payable, obligations payable, the portion of long-term debt due, other accounts payable, and accrued taxes and wages payable.

In general, the higher the current liquidity, the more liquid the company has. The amount of liquidity a company needs depends on several factors, including the size of the organization, its access to short-term sources of financing, such as bank lines of credit, and the volatility of its business. For example, a grocery store whose revenues are relatively predictable may not need as much liquidity as a manufacturing company facing sudden and unexpected changes in demand for its products. The more predictable a company’s cash flows are, the lower the acceptable current liquidity.

Acid test or quick reason

A measure of liquidity that is calculated by dividing the company’s current (current) assets, less inventory, by its current (current) liabilities.

 

Cash + Cash Equivalents + Marketable Securities + Current Accounts Receivable/Total Current Liabilities

The acid test ratio equation may also be calculated as:

Total Current Assets – Inventory – Prepaid Assets / Total Current Liabilities

This financial ratio is a more stringent measure of liquidity. By eliminating inventories from current assets, the financial reason recognizes that these are often one of the least liquid current assets. Inventories, especially work in process, are very difficult to quickly convert to or near book value. Low inventory liquidity is generally due to two primary factors: 1. Many types of inventory cannot be easily sold because they are part-finished products, special purpose items, or the like; and 2. inventory is generally sold on credit, which means it becomes an account receivable before it becomes cash. An additional problem with inventory as a liquid asset is that when companies face the most pressing need for liquidity, that is, when business is bad, that is precisely the time when it is most difficult to convert inventory into cash through its sale. The fundamental assumption of the acid test is that a company’s receivables will be convertible to cash within the “normal” recovery period (and with little “reduction”) or within the term in which credit was originally extended.

As in the case of current liquidity, the level of the quick ratio that a company should strive to achieve depends largely on the industry in which it operates. The quick ratio offers a better measure of overall liquidity only when the firm’s inventory cannot be readily converted to cash. If the inventory is liquid, current liquidity is a preferable measure for overall liquidity.

Cash ratio

A company’s most liquid assets are its holdings of cash and readily-sale securities. This is why analysts also look at the cash ratio, which is calculated as cash plus short-term securities divided by current liabilities.

Cash Ratio = Total Cash & Cash Equivalents / Current Liabilities

Bibliography

  • Brealey, Richard A., Myers, Stewart C., and Allen, Franklin. Principles of corporate finance. McGraw-Hill Inter-American Publishers. 2010.
  • Duran Herrera, Juan Jose. Finance dictionary. Ecobook, Economist Editorial, 2011.
  • Gitman, Lawrence J. and Zutter, Chad J. Principles of Financial Management. Pearson Education, 2012.
  • Moyer, Charles R., McGuigan, James R., and Kretlow, William J. Contemporary Financial Management. International Thomson Publishers. 1999.
  • Sepúlveda L., César (Editor). Dictionary of economic terms. University Press, 2004.

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