Liquidity ratios are used to evaluate and measure a company’s ability to meet the demands for cash as they arise. This article will detail several important liquidity ratios that can be used to analyze a company. Liquidity ratios are not the only type of ratios that can be used to analyze a company. Other types of key ratios that can be used to analyze the financial health of a company include activity ratios, leverage ratios, profitability ratios, and market ratios.
Although financial ratios can be very helpful, it is important to understand that they also have their limitations: they can be used to screen potential companies for different purposes, show trends in how the company is managed, and indicate possible strengths and weaknesses of the company, however they do not provide answers in and of themselves and are not predictive. It should be noted that in order to see the whole picture, other factors must be considered. When analyzing a company, their ratios should not only be compared to their competitors, but also to industry averages.
Popular Liquidity Ratios
Current Ratio = Current Assets / Current Liabilities
The current ratio is used to show a company’s ability to meet its short term debt requirements. It is important to understand that the current ratio uses current liabilities and not total liabilities. A current ratio of 1 means that the firm has the same amount of current assets as it does current liabilities, and that if all of the current liabilities come due, the company has enough assets to cover them. A strong current ratio, depending on the industry, is between 1.2 and 2. Anything below 1 is problematic as this means that the company does not have enough current/liquid assets to cover all of their current liabilities. For instance, at year end 2018 Tesla, Inc.’s current ratio was .83 and at year end 2017 the ratio was .86.
The current ratio has some limitations as the figures used to calculate this ratio, as well as others, are found on the company’s balance sheet which is as of a specific date in time, usually at year end. Also, current assets such as accounts receivable and inventory may not be truly liquid.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
The quick ratio, which is also known as the acid-test, is similar to the current ratio however removes inventory from current assets, as inventory may not be truly liquid. This ratio is a better representation of a company’s short-term liquidity in case all of the current liabilities came due.
A good rule of thumb to use when calculating the quick ratio is to only use the assets that can be easily converted to cash within 90 days. Inventory is not one of these because if a company had to liquidate their entire inventory within a 90 day period they will probably have to do so by offering deep discounts. A quick ratio higher than 1 means that a company has more than enough highly liquid assets to cover short term liabilities. Tesla, Inc.’s quick ratio at year end 2018 and 2017 was .52 and .56, respectively.
Cash Flow Liquidity Ratio = (Cash + Cash Equivalents + Marketable Securities + Cash Flow From Operating Activities) / Current Liabilities
Another way to measure the short term liquidity of a company is by calculating the cash flow liquidity ratio. This ratio not only includes balance sheet figures but also considers cash flow from operating activities which is found on the statement of cash flows, and represents the amount of cash a company can generate from normal operations such as selling inventory. For the years ending 2018 and 2017, Tesla, Inc. had a cash flow liquidity ratio of .58, and .43.
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
The cash ratio is similar to the cash flow liquidity ratio however the cash ratio only considers a company’s most liquid assets. This ratio can be used to determine how a company may handle a worst case scenario – for instance if all of a company’s short term liabilities come due, how much cash does the company have to use to pay these? A cash ratio of 1 is definitely sufficient, and would make creditors and investors feel safe either lending to the company or investing in the company. However, depending on the type of company and the industry it operates in, a high cash ratio may mean that the company isn’t managing cash as effectively as it could be.
Liquidity ratios such as the current ratio, quick ratio/acid test, cash flow liquidity ratio, and the cash ratio offer great insight on a company’s short term liquidity. However, when analyzing a company the liquidity ratios should not be the only metrics considered.