Liquidity is a crucial aspect of a firm’s financial analysis, focusing primarily on the company’s ability to meet its short-term liabilities. It is mainly defined by how quickly assets can be converted into cash with minimal or no loss in value. Understanding liquidity helps in comparing the financial health and stability of businesses, providing valuable insights for investors. In this guide, we will break down the steps involved in calculating liquidity in the simplest way possible.
What is Liquidity?
Liquidity refers to a firm’s ability to quickly convert assets into cash with minimal loss in value. It’s crucial to ensure that a company can promptly meet its short-term liabilities. High liquidity allows a firm to access cash for needs like paying debts and covering other financial obligations without having to sell fixed assets. In essence, liquidity measures a business’s capacity to cover short-term obligations using readily available resources. As it impacts a firm’s ability to handle current expenses and unexpected events, liquidity is essential for maintaining smooth operations and ensuring financial stability.
Key Liquidity Ratios
To measure liquidity, several key ratios are commonly used, such as current ratio, cash ratio, and quick ratio.
Let us look at the each type of liquidity ratio calculation:
- Current Ratio
The current ratio is also called the working capital ratio of a company that looks at the capacity of the organization to cover debts due within the next 12 months using your current assets. It’s one of the simplest business liquidity ratios to understand. Here is how it’s calculated:
Current Ratio= current assets / current liabilities
Example:
If a company has £100,000 in current assets and £60,000 in current liabilities, the current ratio is 1.67. See the calculation below:
Current Ratio= £100,000/ £60,000 =1.67
A value of more than one is an indication that the company is in a position to pay for all the short-term obligations out of its current assets.
- Quick Ratio (Acid-Test Ratio)
The quick ratio, also known as the ‘acid test ratio,’ evaluates your ability to meet current liabilities using assets that can be quickly converted into cash with minimal loss in value. Unlike the current ratio, which considers all current assets, the quick ratio focuses only on assets that are highly liquid: accounts receivable (amounts owed by clients), marketable securities (easily tradable assets), and cash on hand.
The quick ratio formula is:
Quick ratio = (cash + accounts receivable + marketable securities) / current liabilities
Example:
For instance, if your cash, accounts receivable, and marketable securities total £75 million and your current liabilities are £50 million, your quick ratio would be 1.5.
A quick ratio of 1.5:1 is generally considered good, indicating you have sufficient liquid assets to cover your short-term obligations.
3. Cash Ratio
The cash ratio is the most conservative liquidity ratio, as it considers only cash and cash equivalents. It provides insight into your business’s financial health and is also used by lenders to assess your ability to repay debt.
See how the cash ratio is calculated:
Cash Ratio=Cash + Cash Equivalents/ Current Liabilities
Example:
If the company has £30,000 in cash and cash equivalents and current liabilities £60,000, then cash ratio would be:
Cash Ratio=£30,000/£60,000=0.50
Any cash ratio below 1 indicates that a company does not have an ability to cover the current liabilities with cash assets.
Why Does Liquidity Matter in Business?
It is critical for several reasons.
- Operational Continuity: This ensures that a company is able to run its operation without any interruption.
- Financial Flexibility: With enough liquid assets, a company can quickly take advantage of promising opportunities or respond to urgent threats without being constrained by financial limitations.
- Creditworthiness: Thus, a higher liquidity ratio usually enhances the credit rating of the concerned company.
Tips for Managing Liquidity
- Monitor Ratios Regularly: Keep an eye on key liquidity ratios to identify any potential issues with your short-term financial outlook.
- Maintain Cash Reserves: Ensure you have sufficient cash reserves to cover liabilities for each accounting period.
- Optimise Inventory: Convert fixed assets to cash, manage employee share plans, and reduce material inventory to boost cash flow.
- Improve Receivables: Accelerate the collection of accounts receivable to enhance your business’s cash position.
Seek Expert Financial Guidance in the UK
In order to handle your company’s financial status well and enhance the working capital, it is recommended to seek expert guidance from TaxCan Accountants & Cangaft Ltd. Our experts will advise you on the best strategies that can improve financial management and keep adequate cash on hand.
Conclusion
Liquidity planning and control are essential for the successful management and projection of any company. By evaluating ratios like the current ratio, quick ratio, and cash ratio, you can gauge the company’s effectiveness in handling short-term debts. This approach helps ensure proper cash flow management and maintains a strong liquidity position.
For further guidance on business liquidity ratios, consult TaxCan Accountants and Cangaf Ltd.
