4 Common Liquidity Ratios in Accounting
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4 Common Liquidity Ratios in Accounting
One way a business can manage its books and viability in the near and long terms is to see how liquid its assets are. Businesses that have better cash positions are naturally geared toward sustaining continued success. One important reason for a business to measure and maintain healthy levels of liquidity is because it promotes better odds that a company will be able to satisfy its short-term debts. There are many ways a business can accomplish this, and below are four common ways it can be done.
One of the few liquidity ratios is what's known as the current ratio. It's a way to determine how well a company can pay back its debts.
The current ratio is also known as the "working capital ratio," showing how well a business can satisfy financial obligations that must be paid back within 12 months. Using an example is a good way to see how it works:
Let's assume a company has the following assets, it would use the following ratio:
Current Ratio = Current Assets / Current Liabilities
Marketable Securities such as stocks, bonds or purchase agreements maturing in 12 months or less can be considered a current asset. Businesses may also consider cash, accounts receivable, prepaid expenses, office supplies and saleable inventory they have in stock as current assets.
Outstanding bills or accounts payable and short-term debt – within the next 12 months as described above – are considered current liabilities. Other expenses can be interest payable, income and payroll taxes payable, which can also be considered current liabilities.
If the current assets of a business are $250 million, and that is divided by current liabilities of $75 million, the Current Ratio would be 250 / 75, or 3.33
With a current ratio of 3.33, the company is in good financial health because it can pay off its debts easily.
The Acid-Test Ratio determines how capable a company is of paying off its short-term liabilities with assets easily convertible to cash.
Also known as the quick ratio, the formula is as follows:
Acid-Test Ratio = Current Assets - Inventories / Current Liabilities
Current assets consist of cash and similar assets (savings/checking accounts, deposits becoming liquid in three months or less), marketable securities and accounts receivable. From there, the summation is divided by the company's current liabilities expected to be paid in 12 months.
The other way to calculate the acid-test ratio or quick ratio is as follows:
The first step is to look at the company’s current assets that can be liquidated within 12 months. Then inventory must be valued – that which is intended to be sold for purchase. From there, the inventory value is subtracted from the current assets. The resulting value is then divided by the business' current liabilities.
The acid-test ratio is one way to determine a company's ability to satisfy current liabilities without selling inventory or getting more lending. With the uncertainty and profitability of selling inventory, one can argue that it gives a better picture of a company's financial fitness.
For example, if a company comes out with a ratio of 3, this means that a business has $3 for every $1 of liabilities. However, as a company's quick ratio increases, it might show there's too much money not being reinvested to increase the company's efficiency and profitability. A higher quick ratio figure can also indicate that there are too many accounts receivable that are owed but uncollected by the company.
As the name implies, the cash ratio determines how financially able a company is to satisfy short-term liabilities with cash and cash equivalents.
Also referred to as the cash asset ratio, this tells how capable a business is of satisfying short-term debts, usually 12 months or less, with cash and cash equivalents only. This ratio is as follows:
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
Examples of cash and cash equivalents include physical currency, minted coins, and checks. Cash equivalents include money market accounts, Treasury bills and anything that can be converted into cash in almost real-time.
When it comes to current liabilities, accrued liabilities, short-term debts and accounts payable are examples that are due within one year.
From there, the ratio is as follows to determine a company's cash asset ratio:
Cash and Cash Equivalents (Cash: $25,000 + Cash Equivalents: $100,000) / Liabilities (Accounts Payable: $30,000 + Short-term debt: $25,000)
$125,000 / $55,000 = 2.27
Based on this calculation, the company would be able to pay off 227 percent of present liabilities with its cash and/or cash equivalents. For creditors and investors evaluating a company, it can show the company has ample liquidity. Creditors are naturally more willing to lend to companies with more cash flow; and investors are interested to see how liquidity is being managed.
Operating Cash Flow Ratio
This ratio measures how efficiently a business can meet present liabilities from the cash flow of its core business operations. It tells a company the number of times over it can satisfy its liabilities based on the amount of cash it generated over a certain time-frame.
This ratio can also include accruals, giving a fair estimate of a business's short-term liquidity. The formula to determine this ratio is as follows:
Operating Cash Flow Ratio = Cash Flow from Operations / Current Liabilities
The statement of cash flow is where the operation’s cash flow is found. It can also be calculated by determining a company's net income, plus non-cash expenses, plus working capital changes.
Current liabilities are defined as financial obligations due within the next 12 months. Common ones are accrued liabilities, accounts payable and/or short-term debt.
Once the operating cash flow ratio is calculated, a company's financial health can be determined. If the ratio is 1.5 or 2, for example, it means the company can cover 1.5 times or double its present liabilities. However, if the ratio is less than 1, then the amount of cash generated from operations is insufficient to satisfy short-term liabilities.
As part of a comprehensive accounting practice, businesses that run these ratio calculations will be able to identify where there's too little or too much liquidity and reduce current and future financial peril.
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.