The Value of Liquidity Ratios
Liquidity is the ability to convert assets into cash quickly. Learning about each of these ratios can help you identify trends as well as make changes to your operations. Comparing them internally to previous time periods allows you to track changes. While comparing to industry averages gives insight into your performance and positioning in relation to competitors.
Assets like accounts receivable, securities, and inventory are relatively easy to convert into cash. Additionally, they create a margin of safety for companies. Hence, liquidity calculations use all these assets. Several ratios can be used including the current ratio, quick ratio, and operating cash flow ratio. Keep in mind these ratios vary from industry to industry.
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Current Ratio
The current ratio is a liquidity and efficiency ratio that measures a firm’s ability to pay off short-term liabilities with current assets. Short-term liabilities are due within the next year. As such, raising capital comes with a time constraint. Current assets like cash, cash equivalents, and marketable securities can easily convert into cash. Large amounts of current assets make paying off current liabilities easier without the need to sell long-term, revenue-generating assets. The current ratio calculates as:
Current Ratio = Current Assets / Current Liabilities
The higher this ratio the stronger the company’s liquidity position. This ratio helps investors and creditors understand how easily a company can pay off its current liabilities. For instance, a ratio of 3 would mean a company has 3 times more current assets than current liabilities. A common rule of thumb is that the ratio should at least be 2.0. The higher this ratio the easier a company can make current debt payments. One flaw of this ratio is that it includes inventory as a current asset. In some business’s inventory may not easily convert into cash.
Quick Ratio
The quick ratio measures a company’s ability to meet short-term obligations with its most liquid assets. Thus, it excludes inventory from its current assets. It is also known as the “acid-test ratio.” It computes as:
Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
Quick assets are current assets that can convert into cash within 90 days. As with the current ratio, a company should have enough quick assets to cover its current liabilities without having to sell long-term assets. In most companies, long-term assets generate revenue. As such, selling these will only hurt the company.
A quick ratio of 1 indicates that quick assets equal current liabilities. Higher ratios are a good sign for investors, but an even better sign to creditors as they want to know they will be paid back on time. If the ratio is less than 1, it shows lenders and investors that current operations aren’t making enough profit to pay off current liabilities.
Operating Cash Flow Ratio
The operating cash flow ratio measures the number of times a company can pay off debt with cash generated in the same period. This ratio compares cash and easily convertible investments to current liabilities. It is the most conservative of the liquidity ratios. The ratio calculates as:
Operating Cash Flow Ratio = Cash Flow from Operations / Current Liabilities
Cash flow from operations is the cash equivalent of net income. It is the cash flow after operating expenses are deducted and before investments or financing. The operating cash flow ratio is a refinement of the quick ratio and indicates the extent to which readily available funds can pay off current liabilities. As such, it is useful in situations where current liabilities are due in the very near future.
Ratios in Use
Liquidity is the ability to convert assets into cash quickly. Learning about each of these ratios can help you identify trends and make changes to your operations. Comparing them internally to previous time periods allows you to track changes. While comparing to industry averages gives insight into your performance and positioning in relation to competitors.
Financial analysis in business valuations computes liquidity ratios and presents them in the business valuation report. We at Peak Business Valuation would love to help you understand your financial analysis and how to use it to grow your business. We are happy to answer any questions you have. Please reach out by scheduling a free consultation.
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