Liquidity ratios : Explained

How do I measure if a company has enough cash/liquid assets to pay its short term debt?

Liquidity ratios, as explained in the previous post here, are the ratios that measure the ability of a company to meet its short-term debt obligations. These ratios measure the ability of a company to pay off its short-term liabilities when they fall due

As a general rule, higher the liquidity ratios, higher the margin of safety that the company possesses to meet its current liabilities

If the value is greater than 1, it means the company’s short-term debt obligations are covered. So, higher the ratio above 1, the better is the financial health of the company, and higher the chances of the company doing well in the stock market

There are 3 liquidity ratios which are commonly used:

1. Cash ratio

2. Quick ratio/Acid-test ratio

3. Current ratio/Working captial ratio

Let’s understand these ratios with a simple example:

Marvel Inc. is a company which is into the business of manufacturing and selling cars

And its financial statements read as follows:

Given this scenario, let’s understand if Marvel has enough money to address its short term liabilities by looking at the values of the 3 ratios:

1. Cash ratio:

= (Cash + Cash Equivalents) / Current liabilities

= (20+30)/60

= 0.9

0.9 is slightly less than 1, so looks like Marvel does not have enough (cash in hand + investment in Disney stock) to pay its short-term debt

2. Quick ratio:

= (Cash + Cash Equivalents + Accounts receivables) / Current liabilities

= (20+40+30)/60

= 1.5

It is >1.5. So, if we take into account, the amount that is yet to be received for the previous cars sold along with (cash in hand + investment in Disney stock), the company is well placed to pay for its short-term obligations

3. Current ratio or Working capital ratio:

= (Current Assets / Current liabilities)

= (Cash + Cash Equivalents + Accounts receivables + Inventory ) / Current liabilities

= (20+40+30+80)/60

= 2.8

So, if you include the unsold inventory of cars as well along with (cash in hand + amount to be received from sale of previous cars + investment in Disney stock) , Marvel has enough to pay off the short term debt, hence it is financially well off

If you observe, cash ratio, quick ratio and current ratio are all very similar, just that cash ratio is the most conservative ratio among the 3 ratios discussed above

However the most commonly used liquidity ratios are Quick ratio & Current ratio, and for a financially healthy company, these ratios should generally be greater than 1

Other terms used to track liquidity:

There are two other terms which are not necessarily ratios but commonly used and covered under liquidity ratios:

1. Working capital

Working capital gives us an idea of company’s ability to meet short term obligations. It is similar to current ratio, the difference being, current ratio is a ratio and working capital is an absolute difference. The purpose they serve is more or less the same.

Let's calculate WC for Marvel

Working capital

= (Current assets – Current liabilities)

= (Cash + Accounts receivables + Cash Equivalents + Inventory) – Current liabilities

= ( 20+40+30+80 – 60)

= 110

Here, the WC is positive and way above 0, hence Marvel is well placed to handle its short term liability obligations, just like we have seen in current ratio

2. Days working capital

It is a measure of efficiency of the company to turn working capital into sales. It is a very important in the sense that it is a measure of company’s liquidity, efficiency and overall health as it includes everything from cash, inventory, accounts receivables to short term liabilities

Days working capital = (Working capital* 365 / Annual sales)

Rule : The less the value than its competitors, the better. Less number of days implies the company is efficient in managing debts, inventory and using the net assets to turn into sales quickly than its peers in the same industry

Let's calculate for Marvel. Let’s assume Marvel has annual sales of Rs.1000

Days working capital

= (Working capital* 365 / Annual sales)

= (110*365)/1000

= 40.15 days

So, it takes Marvel 40 days to convert working capital into sales

If Tata Motors, let’s say, has 50 as days working capital, then it’s a fair indication that Marvel is more efficient in its day-to-day business of managing debt and earning revenues as compared to Tata Motors

One more way companies use days working capital is by looking at it's trend for the past few years

• If a company's working capital is increasing, implies the sales are decreasing or the short term debt is increasing, which is a concern for the company

• Similarily, if the working capital is decreasing, it could mean sales are improving or the short term debt obligations are decreasing, which is a good sign for the company

Hope the liquidity ratios are now clear and you will be able to analyse these on your own for your company of interest going forward, to understand if it is in a good position to meet it's short term debt obligations

We’ll look at the next set of ratios, which are the leverage ratios, in our next post