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What Are Liquidity Ratios

Liquidity ratios measure a company's ability to pay off current debts by analyzing current assets versus current liabilities. Common liquidity ratios include the current ratio and quick ratio. Liquidity ratios are most useful when compared over time or to other companies to evaluate financial positioning and changes. A liquidity crisis can arise if short-term obligations cannot be met, as seen in the 2007-09 credit crunch, but solvent companies can typically resolve liquidity issues by raising cash. Solvency ratios differ by measuring total assets versus total liabilities to assess overall debt obligation abilities.

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50 views2 pages

What Are Liquidity Ratios

Liquidity ratios measure a company's ability to pay off current debts by analyzing current assets versus current liabilities. Common liquidity ratios include the current ratio and quick ratio. Liquidity ratios are most useful when compared over time or to other companies to evaluate financial positioning and changes. A liquidity crisis can arise if short-term obligations cannot be met, as seen in the 2007-09 credit crunch, but solvent companies can typically resolve liquidity issues by raising cash. Solvency ratios differ by measuring total assets versus total liabilities to assess overall debt obligation abilities.

Uploaded by

Darlene Sarcino
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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What Are Liquidity Ratios?

Liquidity ratios are an important class of financial metrics used to determine a


debtor's ability to pay off current debt obligations without raising external capital.
Liquidity ratios measure a company's ability to pay debt obligations and its
margin of safety through the calculation of metrics including the current
ratio, quick ratio, and operating cash flow ratio.

Current liabilities are analyzed in relation to liquid assets to evaluate the


coverage of short-term debts in an emergency.

Understanding Liquidity Ratios


Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity
ratios are most useful when they are used in comparative form. This analysis
may be internal or external.

For example, internal analysis regarding liquidity ratios involves using multiple
accounting periods that are reported using the same accounting methods.
Comparing previous time periods to current operations allows analysts to track
changes in the business. In general, a higher liquidity ratio shows a company is
more liquid and has better coverage of outstanding debts.

Alternatively, external analysis involves comparing the liquidity ratios of one


company to another or an entire industry. This information is useful to compare
the company's strategic positioning in relation to its competitors when
establishing benchmark goals. Liquidity ratio analysis may not be as effective
when looking across industries as various businesses require different financing
structures. Liquidity ratio analysis is less effective for comparing businesses of
different sizes in different geographical locations.

Common Liquidity Ratios


The Current Ratio
The current ratio measures a company's ability to pay off its current liabilities
(payable within one year) with its current assets such as cash, accounts
receivable and inventories. The higher the ratio, the better the company's liquidity
position:

Current Ratio=Current Liabilities/Current Assets

Liquidity Crisis
A liquidity crisis can arise even at healthy companies if circumstances arise that
make it difficult for them to meet short-term obligations such as repaying their
loans and paying their employees. The best example of such a far-reaching
liquidity catastrophe in recent memory is the global credit crunch of 2007-09.
Commercial paper—short-term debt that is issued by large companies to finance
current assets and pay off current liabilities—played a central role in this financial
crisis.

A near-total freeze in the $2 trillion U.S. commercial paper market made it


exceedingly difficult for even the most solvent companies to raise short-term
funds at that time and hastened the demise of giant corporations such as
Lehman Brothers and General Motors Company (GM).

But unless the financial system is in a credit crunch, a company-specific liquidity


crisis can be resolved relatively easily with a liquidity injection, as long as the
company is solvent. This is because the company can pledge some assets if
required to raise cash to tide over the liquidity squeeze. This route may not be
available for a company that is technically insolvent since a liquidity crisis would
exacerbate its financial situation and force it into bankruptcy.

The Difference Between Solvency Ratios and Liquidity


Ratios
In contrast to liquidity ratios, solvency ratios measure a company's ability to meet
its total financial obligations. Solvency relates to a company's overall ability to
pay debt obligations and continue business operations, while liquidity focuses
more on current financial accounts. A company must have more total assets than
total liabilities to be solvent and more current assets than current liabilities to
be liquid. Although solvency does not relate directly to liquidity, liquidity ratios
present a preliminary expectation regarding a company's solvency.

The solvency ratio is calculated by dividing a company's net


income and depreciation by its short-term and long-term liabilities. This indicates
whether a company's net income is able to cover its total liabilities. Generally, a
company with a higher solvency ratio is considered to be a more favorable
investment.

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