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F4 Measuring liquidity
Calculation, interpretation, analysis and evaluation of:
• current ratio: current assets/current liabilities
• liquid capital ratio: (current assets – inventory)/current liabilities
Measuring Liquidity
Measuring Liquidity
A company's liquidity indicates its ability to pay debt obligations, or current liabilities, without having to raise external capital or take out loans. High liquidity means that a company can easily meet its short-term debts while low liquidity implies the opposite and that a company could imminently face bankruptcy.
If a company has plenty of cash or liquid assets on hand and can easily pay any debts that may come due in the short term, that is an indicator of high liquidity and financial health. However, it could also be an indicator that a company is not investing sufficiently.
To calculate liquidity, current liabilities are analysed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency.
Liquidity ratios measure how solvent a business is- that is, how able it is to meet short-term debts. There are two liquidity ratios you will look at here:
Current Ratio
Acid Test Ratio/liquidity ratio(Liquid capital ratio)
Current Ratio
This is calculated using the following formula:
Current assets/current liabilities
This shows the amount of current assets in relation to current liabilities and is expressed as x:1. If a firm had a ratio of 2:1, this would mean that for every £2 it owned in current assets, it owed £1 in current liabilities, and this would generally be considered acceptable.
If however a firm had a current ratio of 0.5:1, this would mean that, for every 50p it owned in current assets, it owed £1 in current liabilities. This means if the firm's bank demanded that it repaid an overdraft immediately and it's creditors demanded payment, the firm would not be able to cover these demands from current assets. This is not a good position for a business to be in. The term illiquid means not easily converted into cash.
Liquid assets refer to cash on hand, cash on bank deposit, and assets that can be quickly and easily converted to cash. The common liquid assets are stock, bonds, certificates of deposit, or shares.
Solvency is the ability of a company to meet its long-term debts and other financial obligations. A business is considered solvent if the value of its assets is greater than its liabilities.
Liquid Capital Ratio
Liquid Capital Ratio
This is calculated using the following formula:
(Current assets-inventory)/ current liabilities
The liquid capital ratio is thought to be a tougher measure of a firm's liquidity. Like the current ratio, it shows the amount of current assets in relation to current liabilities, but it does not include inventory. This is because inventory is considered to be the hardest current asset to turn into cash quickly. The result is expressed as x:1
How to improve Liquidity
How to improve Liquidity
Paying off liabilities also quickly improves the liquidity ratio, as well as cutting back on short-term overhead expenses such as rent, labor, and marketing.
Additional means of improving a company's liquidity ratio include using long-term financing rather than short-term financing to acquire inventory or finance projects. Removing short-term debt from the business allows a company to save some liquidity in the near term and put it to better use.
Ensure that you're invoicing customers as quickly as possible, and they're paying on time. When it comes to accounts payable, you'll want to ensure the opposite—longer pay cycles are more beneficial to a company that's trying to improve its liquidity ratio. You can often negotiate longer payment terms with certain vendors.
A company that can pay its business expenses and pay down its debts through the profits it generates from its business operations and efficient use of assets is one that is likely to succeed and grow.
Liquidity ratios, which measure a firm's capacity to do that, can be improved by paying off liabilities, cutting back on costs, using long-term financing, and managing receivables and payables. That being noted, a higher liquidity ratio does not always indicate a stronger company, as it could reveal a company that is not managing its assets efficiently to grow its business.
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