Liquidity Ratios

Liquidity is the ability to convert an asset into cash quickly, and ideally without losing money. By its nature, liquidity addresses the short term, but it is not a trivial matter. By some accounts, it was liquidity problems that caused Lehman Brothers’ bankruptcy, one of the biggest financial calamities in modern times. 

Current Assets vs. Current Liabilities

Like profit margins, the most prominent liquidity ratios are simple and easy to understand and can all be derived from a single financial statement ― the Balance Sheet.

Below is the Balance Sheet we re-visited when we reviewed activity ratios. We shall use it to perform a complete ratio analysis in our practical example.

As liquidity concerns the short term, liquidity ratios are generally obtained from the current portion of assets and liabilities. An analyst can make all sorts of combinations between assets and liabilities depending on the industry under review, the nature of the business, and the purpose of the analysis. Four balance sheet ratios are considered to be the most insightful according to the majority of practitioners:

  • The Current Ratio
  • The Quick Ratio
  • The Cash Ratio
  • The Defensive Interval

Current Ratio

The Current Ratio reflects the company’s ability to cover its short-term obligations. Basically, it helps us determine whether the value of the firm’s current assets exceeds the value of the firm’s current liabilities by comparing both line items:

Current~Ratio=\frac {Total~Current~Assets}{Total~Current~Liabilities}

The higher the current ratio, the better the liquidity position of a firm. This implies that the company can cover its short-term obligations by liquidating its current assets. By contrast, a current ratio below 1 is a red flag that a firm can be quickly rendered unable to pay its bills and pushed into insolvency.

While this is a simple and intuitive measure to observe, astute analysts will quickly point out that current assets are not all liquid. Pre-paid expenses, for example, cannot be liquidated. And inventory’s book value is rarely the same as its market value; certainly not when one needs to liquidate it urgently, at fire-sale prices. That’s why the quick ratio has been introduced in liquidity analysis.

Quick Ratio

The Quick Ratio (a.k.a. the Acid Test) deals with current assets that are quick to liquidate. It essentially answers the question, “Are there enough quick assets to meet short-term obligations if the firm faces a sudden liquidity crisis?” The most common quick assets are cash, marketable securities, and accounts receivable:

Quick~Ratio=\frac {Cash+Marketable~Securities+Accounts~Receivable}{Total~Current~Liabilities}

The higher the quick ratio, the more comfortably the company can face adverse liquidity events.

Cash Ratio

The Cash Ratio considers whether the company can meet its obligations at short notice. It answers the question, “Does the firm have enough cash to cover its short-term obligations should the need arise?” The higher the ratio, the better equipped the firm is to meet disastrous events. Marketable securities are also included alongside cash, simply because they are quick to liquidate just as a bank deposit is:

Cash~Ratio=\frac {Cash+Marketable~Securities}{Total~Current~Liabilities}

The cash ratio is rather conservative and must be taken with a pinch of salt. A result greater than 1 may sound like good news from a liquidity standpoint, but it certainly bears scrutiny on the efficiency front. A high cash ratio may indicate that management cannot utilize the cash that the business generates and struggles to find investment and growth opportunities.

A cash ratio lower than one, on the other hand, may not be necessarily bad news, especially if the firm has short credit terms with clients, efficient inventory management, and a short net trade cycle.

The Defensive Interval

The Defensive Interval looks at the company’s quick assets as a sort of an emergency cash deposit. In other words, it assesses the firm’s ability to cover its daily expenses in a sudden loss of all income. At its core, it answers the question of how many days the company could keep running if it received no income at all.

Like activity and ROI ratios, it takes items from the balance sheet and the income statement. The defensive interval calculates average daily cash expense by taking the company’s annual expenses, minus non-cash charges like depreciation, and dividing them by 365:

Average~Daily~Cash~Expenses=\frac {(Annual~COGS+Annual~Operating~Expenses - Non–Cash~Charges)}{365}

It then divides the quick assets by the average daily cash expense to obtain the number of days those quick assets can cover:

Defensive~Interval=  \frac {Cash + Marketable~securities + Receivables}{Average~Daily~Cash~Expenses}

The higher the ratio, the longer the company can survive without income, or without using external financing, or without depleting its long-term assets. While this is the universally accepted formula for the defensive interval, there can be different iterations, depending on the circumstances. We may want to include interest and principal payments from the cash flow statement – after all, they are a cash expense. At times, companies might deem it necessary to add liquid inventory to the equation.  And if the company has no revenue and stops production, COGS may get excluded from the formula.

Often classified as a financial efficiency ratio, the defensive interval ratio is more commonly included in the liquidity group, and it is even considered to be the best liquidity ratio by some analysts.

Conclusion

Liquidity ratio analysis is an integral part of financial analysis that should never be overlooked. Although it is quite insightful to examine profitability, efficiency, and return of an organization, liquidity risks remain very real and very destructive, as the 9/11, Lehman, and COVID crises have demonstrated.

Now that we’ve examined how to appraise a company’s ability to meet its short-term obligations, we turn to solvency ratios, which depict a firm’s ability to meet its long-term obligations.

We recommend you take a look at solvency ratios next!


If you want to find out how to calculate these ratios in Excel, take a look at our liquidity ratios model.