Liquidity ratios are very important ratios which describe the company's ability to meet its short term obligations. Liquidity shortfalls (liquidity ratios of less than 1) indicate cash flow problems and may require the company to acquire short term financing on short notice (usually the larger and more urgent the need for "convenient" cash, the more expensive the financing).
The three most common liquidity ratios are the Current ratio, Quick ratio and Cash ratio (increasingly conservative ratios). These ratios are also related to the activity ratios we had previously discussed.
In each of the ratios the denominator is the current liabilities.
Current Ratio
Current Ratio = Current Assets / Current Liabilities
Probably the easiest to calculate (seeing as Current Assets is a line item in a Balance Sheet). It is the broadest liquidity ratio, including all current assets. As a result it is also the least conservative.
Quick Ratio
Quick Ratio = [Cash + Equivalents + Receivables] / Current Liabilities
While Current Ratio takes into consideration all of your assets, what if you determine that your inventory is not liquid enough (not enough turn over) to be able to contribute to your liquidity (maybe you sell large products infrequently - looking at your inventory turn over should give you an idea). By removing inventory from consideration as relatively illiquid, the quick ratio is a more conservative measure of liquidity.
Cash Ratio
Cash Ratio = [Cash + Equivalents] / Current Liabilities
The most conservative of all ratios is the cash ratio. It literally assumes that all your receivables go into default (doesn't include them in the numerator) and is very much a "bird in the hand is better than two in the bush" measure of liquidity. A company with a cash ratio of 1 or higher has a very low likelihood of short term cash flow issues as they can cover all their liabilities with cash.
While having a high liquidity ratio is generally good, having TOO high a liquidity ratio can be just as bad. How is that? Because it means that you are inefficiently using your capital. A company which has good asset turn over and few default accounts would be foolish to have a Cash Ratio of 1. Having liquidity is another form of safety, and following the golden rule of investing: the more risk you can reasonably assume, the more return you can expect.
[Example] A company has a Current ratio of 2, a Quick ratio of 0.9 and a Cash ratio of 0.8. If the company is about to order more supplies to create more inventory, what is the net effect on each ratio?
[Solution] First, assuming that the value of the supplies (AP a current liability) is equal to the increase in inventory (Inv a current asset), the net affect will be as follows:
- For a ratio containing inventory in the numerator, the ratio will approach 1 (numerator and denominator increase at an equal rate, but are still weighted with previous values).
- For a ratio NOT containing inventory in the numerator, the ratio will decrease in size (denominator increases)
- The Current ratio, which contains inventory, but is greater than 1, will get smaller (closer to 1).
- The Quick ratio, which contains inventory, but is smaller than 1, will get larger (closer to 1).
- The Cash ratio, which does NOT contain inventory, will get smaller.
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