Managing your debts demands a thorough knowledge of your company's current assets. Your liquidity ratio is the most basic way to measure your ability to pay your debt obligations and maintain your business.
Unfortunately, less than half (44%) of business owners are making decisions with complete knowledge of their finances, according to a recent survey from OnePoll Data. If this sounds (painfully) familiar, then now's a good time to learn more about ratios for liquidity and how they impact your company.
What is a liquidity ratio?
A liquidity ratio is a financial metric that measures your company's ability to pay off your existing short-term debts with available capital. Common liquidity ratios include current ratio, quick ratio, and days sales outstanding (DSO).
Liquidity ratios measure your current assets and determine whether you have enough working capital to cover your liabilities.
Internal analysis of liquidity ratios
Creditors and lenders often use liquidity ratios when deciding whether to extend credit to your business. But any savvy business owner should understand their liquidity ratio and how to handle their debt obligations.
Your company's liquidity ratio can also be helpful when tracking changes in your business processes. For example, you might compare liquidity ratios across multiple accounting periods to determine whether your ratios are improving.
External analysis of liquidity ratios
A company's liquidity ratios can also be used to determine your competitiveness. You can compare the liquidity ratio of your company to those of similarly-sized competitors to see how you measure up. This might be particularly helpful when establishing benchmark goals.
Just be cautious about the limits of external liquidity ratio analysis. The effectiveness of these comparisons will be strongest when comparing companies of a similar size in a similar geographic region. The results may be less accurate when you compare your company to those of different sizes and territories.
Liquidity ratios vs. solvency ratios
Your liquidity ratio should not be confused with your company's solvency ratio. Solvency ratios measure your company's ability to pay all your financial debts and obligations. Solvency, therefore, looks at your long-term capacity, while liquidity has more to do with your current and short-term debt obligations.
Both are useful when evaluating your business, but liquidity ratios are more relevant when calculating short-term liabilities.
Why does your liquidity ratio matter?
Your liquidity ratio matters because your debts matter. Liquidity ratios measure your company's ability to cover its short- and long-term debts and can be a vital measure of your overall financial health.
Here are three reasons why staying on top of your liquidity ratio is essential by calculating this figure at least once per year, if not once per quarter.
Track your financial health
The liquidity ratio provides insight into your company's finances. High liquidity means you have the working assets to meet your financial obligations. On the other hand, your company could face a liquidity crisis if your debts and loans surpass your current assets.
Having more liquid assets can ensure you have what it takes to meet your short-term obligations, or it could put you in a better position to make short-term investments to improve your business.
Having more liquid assets can ensure you have what it takes to meet your short-term obligations, or it could put you in a better position to make incremental investments to improve your business.
Secure additional funding
Business loans can be a valuable lifeline to businesses of any size. But when you apply for a loan, lenders will often look at your liquidity or cash ratios to help determine your creditworthiness. A strong liquidity ratio can demonstrate to lenders and investors that your company is a worthwhile investment.
Receive a competitive analysis
You can use this financial data to compare your company to other industry leaders. This can be important when setting benchmark goals and charting a course for the future.
Types of liquidity ratios
There's more than one type of liquidity ratio. Each of the three main types of ratios reveals something different about your company's financial health, so it's essential to understand what they measure.
Current liquidity ratios measure whether a company can pay all its current liabilities based on its current assets.
What can you count among your current assets? Your current assets can include things like:
- Accounts receivable
Usually, the current ratio refers to your ability to pay your obligations over the course of one year, so the current ratio doesn't always provide the best measure of how well your company can handle short-term debt.
The quick ratio relates to your company's ability to meet its short-term obligations. For this reason, the quick ratio is sometimes referred to as the "acid test ratio." The quick ratio relies on your company's most liquid assets, which means that you'll rely on cash and your accounts receivable, but it excludes inventory from your list of current assets.
Days sales outstanding (DSO)
Days sales outstanding (DSO) measures the average time in days that it takes your company to collect a payment following a sale. Here, you want a low DSO. A low DSO means that your company can usually collect payment quickly from your customers and clients.
By contrast, a high DSO typically indicates a problem and can mean that you have capital tied up in your accounts receivable department.
You can improve your DSO by decreasing the time it takes your clients to pay you. For example, implementing invoicing software can encourage customers to make electronic payments on the spot, accelerating your accounts receivable process and giving you direct access to working capital.
What is a cash ratio?
A cash ratio isn't actually a liquidity ratio, but the two are similar enough that you may need to understand how they relate.
Your company's cash ratio is another liquidity measurement focused on your company's ability to cover short-term obligations with ONLY the cash (or cash equivalents) you currently have on hand. This makes it different from other liquidity ratios that consider other assets, including inventory.
How to calculate your cash ratio
You can calculate your company's cash ratio using the following formula:
Again, your cash ratio will rely exclusively on your cash or cash equivalents divided by your liabilities. This makes it more immediate than the three liquidity ratios described above, which depend on various asset classes when assessing your company's strength.
What is a good cash ratio?
A good cash ratio is anything above 1. This type of financial ratio is more direct than your company's liquidity ratio since it looks exclusively at your most liquid asset: cold, hard cash.
If your cash ratio is below 1, don't sweat it—yet. This simply means you have more short-term debts than the assets to cover them, but this can quickly change when you include your other assets in the calculation.
Still, keeping an eye on your cash ratio is important, as this score is also used to determine your creditworthiness when you pursue financing.
How to calculate your liquidity ratio
Now that you understand the common types of liquidity ratios, you'll need to learn how to calculate each. These will give you a good understanding of your company's financial condition.
Current ratio formula
You can calculate your current ratio simply by dividing your current assets by your current liabilities:
While a current ratio will vary by industry, you’ll generally want a high ratio above 1. A high current ratio indicates strong financial stability and reflects your company's ability to pay its debt obligations.
Quick ratio formula
The formula for the quick ratio is as follows:
- C = cash and cash equivalents
- MS = marketable securities
- AR = accounts receivable
- CL = current liabilities
You can calculate your quick ratio simply by adding your current liquid assets and then dividing the sum by your current liabilities.
A simpler version of the formula is as follows:
Remember, your quick ratio reflects your most liquid assets and therefore excludes inventories from the formula.
Daily sales outstanding formula
Your DSO should be calculated at least once per year, though you can also calculate it for each sales quarter. Simply divide your average accounts receivable by the revenue your company generates per day. You can use the following formula:
Here you want to see a low number. A low DSO indicates that you're collecting money on a relatively rapid basis, giving you better cash flow.
What is a good liquidity ratio?
A good liquidity ratio is anything above 1, and higher liquidity ratios reflect a business's financial strength, abiliity to cover its current liabilities, and a reduced likelihood to face financial challenges.
Liquidity ratio: an example
Imagine that you're calculating the liquidity ratios for Company X. The company reports the following financial details:
- Cash/cash equivalents: $10,000
- Marketable securities: $5,000
- Accounts receivable: $7,500
- Inventories: $5,000
- Current assets (a): $27,000
- Equipment (b): $13,000
- Intangible assets (c): $10,000
- Total assets (a+b+c): $50,000
- Current liabilities (d): $15,000
- Long-term debt (e): $40,000
- Total liabilities (d+e): $55,000
- Shareholder's equity: $10,000
Now, you can calculate the liquidity ratios using the above data.
Calculate the current ratio by plugging the above data into the formula:
Current ratio = (current assets) / (current liabilities)
Current ratio = $27,000 (line 5) / $15,000 (line 9)
Current ratio = 1.8
As you see, Company X has a strong current ratio, though it could use some improvement if it wants to wow its investors.
Next, calculate the quick ratio using the formula provided:
Quick ratio = (current assets - inventory - prepaid expenses) / (current liabilities)
Quick ratio = ($27,000 - $5,000) / ($15,000)
Quick ratio = 1.47
The quick ratio for Company X is still greater than 1, showing a strong ability to pay short-term debts.
How to improve your liquidity ratio
What if you have a low liquidity ratio? Here are some ways to achieve a higher liquidity ratio.
1. Cut overheads
One way to improve cash flow is to reduce your overhead liabilities. Many companies cut costs by eliminating paper and going digital for their invoices, receipts, and other financial records.
2. Get paid faster
You'll generally have more working capital if it's not tied up in accounts receivable. Using software to encourage customers to pay rapidly can give you a boost in your cash flow, which you can then put toward your bills and other financial obligations.
3. Look into financing
Some businesses may choose to boost their liquidity ratio by pursuing outside financing. That often means a business loan, though for smaller obligations, you might consider a line of credit. A business line of credit can cover gaps in your cash flow and give you access to more liquidity.
4. Reduce your inventory
Do you have an excess of a particular item in your inventory? You can convert these fixed assets into liquid assets by selling unsold or unnecessary inventory. The same applies to any of your supplies or equipment. You'll liberate liquid assets that can be used to pay vendors or cover other financial obligations.
5. Negotiate new payment terms
Where possible, shift your short-term obligations into long-term debts. This usually reduces your monthly bills and can translate into more cash on hand. Just make sure to account for the extra money you'll spend on the increased interest, as you'll be spending more in the long term.
How BILL can impact your liquidity ratio
BILL can help businesses automate invoicing and get paid 2x faster. A smoother accounts receivable process is one step towards a better liquidity ratio. Learn more now.