Types of Liquidity Ratios: All You Need to Know

Types of Liquidity Ratios: Introduction

When it comes to financing, liquidity is a very important aspect you need to consider. The same reason why liquidity ratio is an equally important accounting tool that can decide the current debt repayment ability of any borrower. 

To put it in more simple terms, the liquidity ratio represents the capabilities of an individual or business when it comes to paying their short-term dues in the absence of any extrinsic assistance. Depending upon the liquid assets the current financial accountability of a company is evaluated in order to validate its safety limit.  

Types of Liquidity Ratios

As an individual or company if you are in possession of a substantial amount of liquid assets then you will have the capacity to settle your short-term financial burdens on time. Let us discuss different types of liquidity ratios.

Current ratio

The current ratio signifies the monetary capability of a company to pay off its current debts by utilizing its current possessions. The assets or possessions can be comprised of prepaid expenditures, stocks, cash, receivables, marketable security deposits, etc. The short-term current debts can imply outstanding expenses, short-term loans, creditors, various other payables, etc.

Formula of current ratio:

Current ratio = current assets / current liabilities

If the current ratio of an individual or company is lower than one then it will imply that their financial performance is negative, which further implies that the individual or company is unable to pay off their current debts with the help of their assets.

Example of current ratio:

Current assets = Rs. 200 crores

Current liabilities = Rs. 50 crores

Current ratio = (current assets / current liabilities)

Rs. 200 crores / Rs. 50 crores = 4:1

Quick ratio or Acid test ratio

The acid test ratio or quick ratio is another form of liquidity ratio that can evaluate a company’s current liquidity. While measuring the quick ratio a company’s present holding of cash and easily convertible (in cash) marketable securities are usually considered. Therefore, the other inventories don’t have any value when it comes to the quick ratio.

The formula for quick ratio:

Below are the two formulas for calculating the quick ratio

• Formula 1: Quick ratio = (marketable securities + available cash and/or equivalent of cash + accounts receivable) / current liabilities
• Formula 2: Quick ratio = (current assets – inventory) / current liabilities

The ideal acid test ratio of a company is 1:1 and it can also reflect the monetary position of a company.

Example of quick ratio:

Cash and equivalent Rs. 70,000 crores

Marketable securities Rs. 20,000 crores

Accounts receivables Rs. 40,000 crores

Inventory Rs. 50,000 crores

Total current assets Rs. 180,000 crores

Total current liabilities Rs. 50,000 crores

• As per formula 1 = (Rs. 20,000 + Rs. 70,000 + Rs. 40,000)/ Rs. 50,000 = Rs. 130,000/Rs. 50,000 = 2.6
• As per formula 2 = (Rs. 180,000 – Rs. 50,000)/Rs. 60,000 = Rs. 130,000/Rs. 50,000 = 2.6

Cash ratio

A company’s most liquid assets such as cash equivalents and cash are measured by the total amount of liability of the same company. Money is considered the most liquid form of assets and the cash ratio can designate the limit and pace of repayment with the assistance of easily available assets.

The formula for cash ratio:

Cash ratio = Cash and equivalent / Current liabilities

Absolute liquidity ratio

The absolute liquidity ratio finds out the difference between current liabilities and the company’s property such as cash, marketable securities, and as such. Any business with an absolute liquidity ratio over 0.5 or over indicates that it is thriving.

The formula for absolute liquidity ratio:

Absolute liquidity ratio = (Cash and equivalent + marketable securities)/current liabilities

Example of absolute liquidity ratio:

Details of liquid assets

Cash and equivalent Rs. 2,00,000 crores

Marketable securities Rs. 80,000 crores

Accounts receivables Rs. 80,000 crores

Inventory Rs. 2,00,000 crores

Current liquid assets Rs. 5,60,000 crores

Details of Current liabilities

Amount Bills payables Rs. 1,00,000 crores

Bank overdraft Rs. 50,000 crores

Outstanding expenses Rs. 50,000 crores

Creditors Rs. 1,00,000 crores

Total current liabilities Rs. 3,00,000 crores

Absolute liquidity ratio = (Rs. 2,00,000 + Rs. 80,000)/Rs. 3,00,000

= Rs. 2,80,000/Rs. 3,00,000

=0.93

Basic defense ratio

The basic defense ratio is a metric through which you will be able to determine how long a company can run depending upon its cash expenses and without the help of any external aid. It is also known as the basic defense interval and defensive interval period.

Formula of basic defense ratio:

• Basic defense ratio = current assets/daily operational expenses
• Current assets = marketable securities + cash and equivalent + receivables
• Daily operational expenses = (annual operational costs – non-cash expenses)/365

Example of basic defense ratio:

Particulars of liquid assets

Cash and equivalent Rs. 1,00,000 crores

Marketable securities Rs. 50,000 crores

Accounts receivables Rs. 70,000 crores

Current liquid assets Rs. 2,20,000 crores

Particulars of daily operational expenses

Annual operating cost Rs. 3,00,000 crores

Non-cash expenses Rs. 50,000 crores

Daily operational expenses Rs. 2,50,000/365 = 684.9

Basic defense ratio Rs 2 20 000/684.9 = 321

Basic liquidity ratio

The basic liquidity ratio is not connected with a company or individual’s monetary position which is unlike any other ratios mentioned above. It is an individual’s financial ratio that represents a timeline for how long a family can sustain themselves with the help of their liquid assets. The minimum financial backup time would be 3 months.

The formula for basic liquidity ratio:

Basic liquidity ratio = Monetary assets / monthly expenses

Significance of Liquidity Ratio

• As a financial metric it helps us determine the current monetary position of a company or individual.
• The cash richness of a company can be understood with the help of the liquidity ratio. It further helps us determine the short-term financial position of a company and a high liquidity ratio can suggest the level of stability of the company. On the other hand, a poor ratio denotes the potential risk of financial damages.
• The liquidity ratio can also display the effectiveness and efficiency of a company and its operating system. By defining this ratio, a company can develop its production system, prepare for overhead expenses, and plan better inventory storage.
• The company can satisfy its working capital requirements with the help of this ratio.
• The management efficiency of a company can be advanced with the help of the liquidity ratio.

Shortcomings liquidity ratio

• The liquidity ratio only considers the number of present liquid assets of the company and that is why it is also recommended to consider other financial metrics combined with the liquidity ratio in order to assess the liquid strength of the company.
• Measuring the liquidity ratio also involves the inventory and overestimation of the inventory can lead to miscalculation. Higher inventory can also indicate fewer sales and the calculation may not display the exact amount of liquidity of the company.
• The liquidity ratio can also become the outcome of creative accounting because it also includes the information on the balance sheet. In order to evaluate the current fiscal position of a company, financial analysts and investors need to look beyond the data provided on the balance sheet and conduct the liquidity ratio analysis accordingly.