Lean on liquidity ratios to calculate the vitality of your business.
Our economy thrives because of the daily transactions—large and small—between sellers and buyers. But have you ever considered what it takes for these transactions to take place? An important factor in market movement is liquidity.
Liquidity is the ease with which an asset or security can be bought and sold at its market price. Since liquid assets can be sold at their full market value, they are important for companies to have to fund short-term financial obligations, such as payroll.
Companies without ample liquidity could face bankruptcy. Therefore, calculating liquidity is an important part of every firm’s financial management. In this article, we explain what liquidity is, the dangers of a liquidity crisis, and how to calculate liquidity ratios for your business.
Understanding liquidity and liquidity ratios
Liquidity considers how easily assets and securities can be bought and sold. To understand liquidity, it’s important to first understand what each of these categories includes.
Assets: An asset is any item with an economic value. It can be owned by individuals, corporations, or countries. Assets fall into several categories, including current assets (e.g., cash), fixed assets (e.g., buildings and facilities), financial assets (e.g., stocks and bonds), and intangible assets (e.g., patents and copyrights).
Securities: Securities include debt and equity. Debt refers to borrowed money to be repaid based on specific terms regarding the loan size, interest rate, and due date (maturity date). Equity refers to company ownership (in the form of stock) by shareholders.
What is a liquidity crisis?
A liquidity crisis occurs when a company cannot meet its short-term financial obligations (e.g., monthly loan payments, building rent, payroll) due to shortage of liquidity. This can lead to adverse financial outcomes, such as bankruptcy, for the company. Therefore, businesses need to keep a close eye on their liquidity, which is calculated through the liquidity ratio.
A liquidity ratio is a financial metric that determines if a debtor can repay current debts using current assets (e.g., cash) and without raising capital from outside sources.
How to calculate liquidity ratios
There are many common types of financial liquidity ratios: current ratio, quick ratio, operating cash flow ratio, and days sales outstanding (DSO). Let’s have a look at each of these.
Current ratio
Current ratio determines a company’s potential to meet current liabilities (all payments due within one year) using current assets, such as cash, accounts receivable, and inventory. Current ratio is calculated using the following equation:
Current ratio = Current assets⁄Current liabilities
Quick ratio
Quick ratio—also known as acid-test ratio—also measures a company’s potential to meet current liabilities using current assets. But unlike current ratio, it doesn’t factor inventory into its equation. Instead, it considers prepaid expenses such as rent, insurance, and other services or goods that have been paid for but not yet utilized. Its formula is as follows:
Quick ratio = Current assets - Inventory - Prepaid expenses⁄Current liabilities
Operating cash flow ratio
Operating cash flow ratio measures how much of a company’s current liabilities are covered by the company’s cash flow—the cash revenue a company earns from the sale of goods and services. It’s calculated using the following equation:
Operating cash flow ratio = Operating cash flow⁄Current liabilities
Days sales outstanding (DSO)
For any company, DSO is a measure of the average days between the sale of an item and the collection of payment for that item. Since cash is necessary for liquidity, it’s necessary for companies to receive payments quickly. A high DSO denotes capital stuck in receivables and, therefore, unavailable for use. The formula for calculating DSO is:
DSO = Average accounts receivable⁄Revenue per day
Want software tools for calculating liquidity ratios?
To gather the best input data for liquidity calculations, consider investment management software. Whether you are an individual investor, traditional investment firm, or alternative investment vendor (such as a hedge fund manager), investment management software can help manage your investment portfolio and financial assets through integrated tools that track portfolio activity, investment funds, and more.