Liquidity Ratios

LEARNING OBJECTIVE

• Use a company's current ratio to evaluate its short-term financial strength

KEY POINTS

• The liquidity ratio expresses a company's ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings.
• The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months.
• Current ratio = current assets / current liabilities.
• Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses.

Liquidity Ratio

Liquidity ratio expresses a company's ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings. It shows the number of times short-term liabilities are covered by cash. If the value is greater than 1.00, it means it is fully covered .

Liquidity ratio may refer to:

• Reserve requirement - a bank regulation that sets the minimum reserves each bank must hold.
• Acid Test - a ratio used to determine the liquidity of a business entity.

The formula is the following:

LR = liquid assets / short-term liabilities

Current Ratio

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm's current assets to its current liabilities. It is expressed as follows:

Current ratio = current assets / current liabilities

• Current asset is an asset on the balance sheet that can either be converted to cash or used to pay current liabilities within 12 months. Typical current assets include cash, cash equivalents, short-term investments, accounts receivable, inventory, and the portion of prepaid liabilities that will be paid within a year.
• Current liabilities are often understood as all liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer.

The current ratio is an indication of a firm's market liquidity and ability to meet creditor's demands. Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses. If a company's current ratio is in this range, then it generally indicates good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets or its short-term financing facilities. This may also indicate problems in working capital management. In such a situation, firms should consider investing excess capital into middle and long term objectives.

Low values for the current or quick ratios (values less than 1) indicate that a firm may have difficulty meeting current obligations. However, low values do not indicate a critical problem. If an organization has good long-term prospects, it may be able to borrow against those prospects to meet current obligations. Some types of businesses usually operate with a current ratio less than one. For example, if inventory turns over much more rapidly than the accounts payable do, then the current ratio will be less than one. This can allow a firm to operate with a low current ratio.

If all other things were equal, a creditor, who is expecting to be paid in the next 12 months, would consider a high current ratio to be better than a low current ratio. A high current ratio means that the company is more likely to meet its liabilities which fall due in the next 12 months.

The Acid Test or Quick Ratio measures the ability of a company to use its assets to retire its current liabilities immediately.

TERM

• Treasury bills

  Treasury bills (or T-Bills) mature in one year or less. Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity.

Quick ratio

In finance, the Acid-test (also known as quick ratio or liquid ratio) measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. A company with a Quick Ratio of less than 1 cannot pay back its current liabilities.

Quick Ratio = (Cash and cash equivalent + Marketable securities + Accounts receivable) / Current liabilities.

Cash and cash equivalents are the most liquid assets found within the asset portion of a company's balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or Treasury bills, marketable securities, and commercial paper. Cash equivalents are distinguished from other investments through their short-term existence. They mature within 3 months, whereas short-term investments are 12 months or less and long-term investments are any investments that mature in excess of 12 months. Another important condition that cash equivalents need to satisfy, is the investment should have insignificant risk of change in value. Thus, common stock cannot be considered a cash equivalent, but preferred stock acquired shortly before its redemption date can be.

Acid Test Ratio

Acid test often refers to Cash ratio instead of Quick ratio: Acid Test Ratio = (Current assets - Inventory) / Current liabilities.

Note that Inventory is excluded from the sum of assets in the Quick Ratio, but included in the Current Ratio. Ratios are tests of viability for business entities but do not give a complete picture of the business' health. A business with large Accounts Receivable that won't be paid for a long period (say 120 days), and essential business expenses and Accounts Payable that are due immediately, the Quick Ratio may look healthy when the business could actually run out of cash. In contrast, if the business has negotiated fast payment or cash from customers, and long terms from suppliers, it may have a very low Quick Ratio and yet be very healthy.

The acid test ratio should be 1:1 or higher, however this varies widely by industry. The higher the ratio, the greater the company's liquidity will be (better able to meet current obligations using liquid assets).