Important Liquidity Ratios to Monitor

Liquidity ratios are one of the most important metrics used to assess a company's financial health and ability to meet its short-term obligations. For companies seeking financing and credit from banks and investors, strong liquidity ratios are key to securing funding approvals. This article will provide an in-depth overview of liquidity ratios - what they are, the key types, how to calculate them, and best practices businesses should follow to maintain adequate liquidity.

Defining Liquidity Ratios

Liquidity ratios measure a company's capacity to pay off short-term liabilities without needing to liquidate longer-term assets. They evaluate the relationship between a company's current assets, which can quickly convert to cash, relative to current liabilities that need to be paid off soon. The higher the liquidity ratio, the better positioned the company is to handle its near-term debt obligations.

There are three primary liquidity ratios used by lenders and investors:

• Current Ratio = Current Assets / Current Liabilities
• Quick Ratio = (Cash + Marketable Securities + Accounts Receivables) / Current Liabilities
• Cash Ratio = (Cash and Cash Equivalents + Marketable Securities) / Current Liabilities

The current ratio provides the broadest assessment of liquidity using all current assets while the quick and cash ratios drill down to just the most liquid assets. Each ratio provides a snapshot of the company's ability to transform assets into cash to handle upcoming liabilities.

Importance for Financing and Credit Approvals

Healthy liquidity ratios are essential for any small business applying for financing. Bankers and lenders analyzing credit applications will review liquidity ratios closely as part of the underwriting process. Here are three reasons liquidity matters so much:

• Demonstrates ability to repay debt - Liquidity shows lenders that the business generates sufficient cash flow to make its loan and interest payments.
• Indicates stability and lower risk - Companies with adequate liquidity are better equipped to handle industry fluctuations or economic downturns without defaulting on obligations.
• Supports access to additional capital - Businesses need to take on debt periodically for growth opportunities. Strong liquidity means better rates and terms on financing.

Key Types of Liquidity Ratios

Now let's examine the three liquidity ratios more closely, how they are calculated, and what the results imply about a company’s financial fitness.

Current Ratio

The current ratio measures a company’s ability to utilize its current assets to satisfy its current liabilities. Current assets include cash, marketable securities, accounts receivable and inventory. Current liabilities consist of outstanding debt, accounts payable, wages and taxes owed.

The current ratio is calculated by dividing total current assets by total current liabilities.

Current Ratio = Current Assets / Current Liabilities

Example: Company A has $2 million in current assets and $1 million in current liabilities. Its current ratio is 2 ($2 million / $1 million).

What it means:

• Ratio above 1.0 means current assets exceed its current liabilities
  • The higher the ratio, the greater the buffer to meet obligations
• Ratio under 1.0 means liabilities exceed assets
  • Company may struggle to pay bills on time

For many industries, an ideal current ratio is between 1.5 to 3.0 for financial stability. Too high could mean inefficient use of capital. Too low indicates risk of defaulting on obligations.

Quick Ratio

The quick ratio is a more conservative measure of liquidity than the current ratio. It excludes inventory and prepaid expenses from assets, as they take longer to convert to cash. It focuses strictly on the most liquid current assets available to meet short-term needs.

Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

Example: Company A has $1.5 million in cash, marketable securities and receivables. It has $1 million in current liabilities. Its quick ratio is 1.5 ($1.5 million / $1 million).

What it means:

• Ratio above 1.0 means highly liquid assets exceed liabilities
  • Strong short-term financial footing
• Ratio under 1.0 means company may have difficulty covering obligations
  • Especially if cash flow or revenue drops

For many industries, an ideal quick ratio for financial health is 1.0 to 1.5. A higher ratio doesn’t necessarily mean better liquidity management. Companies need inventory and credit to operate. But too low leaves little margin for error.

Cash Ratio

The cash ratio is the most conservative liquidity measure, including only cash and cash equivalents in the numerator. It shows the ability to pay off current liabilities immediately with cash on hand.

Cash Ratio = (Cash and Cash Equivalents + Marketable Securities) / Current Liabilities

Example:

Company A has $500K in cash and marketable securities. It has $1 million in current liabilities. Its cash ratio is 0.5.

What it means:

• Ratio above 1.0 means company can pay off all short-term obligations with just cash
  • Maximum liquidity, but maybe too conservative cash strategy
    • Ratio between 0.5 and 1.0 is generally recommended (depending on the industry and business model)
  • Enough to handle some volatility, but not overprioritizing liquidity
    • Ratio under 0.5 generally insufficient
      • High risk of missing obligations during downturns

The optimal cash ratio depends on the industry and business model. But in many cases, a ratio between 0.5 to 1.0 allows companies flexibility to fund operations and growth opportunities while still meeting its near-term commitments.

Conclusion

Liquidity ratios play a crucial role in assessing a company's short-term financial health and stability. Current, quick and cash ratios offer a snapshot of liquidity from different perspectives. As a key indicator of lower risk and creditworthiness, businesses should proactively manage liquidity as part of their financial planning. By following industry best practice benchmarks and ratios for their business model, companies can best position themselves to secure the financing they need to execute growth strategies.