Evaluate how well a company can pay its short-term debts using liquid assets
Download the free financial ratio ebook and find out which seven ratios to use to evaluate the liquidity of any business.
Liquidity ratios are used to measure the ability of a company to pay its short-term debts using liquid assets which can be converted to cash quickly. In this section, we cover the most important liquidity ratios you need to know.
What are liquidity ratios?
Liquidity ratios are metrics that speak of a company’s capacity to cover its financial obligations as soon as they are due. Specifically, these numbers show how many times over short-term liabilities can be paid using the business’ cash and liquid assets. Higher liquidity ratios are generally safer as far as a company’s ability to settle its current liabilities is concerned. Liquidity ratios above 1 show that the business is in a favorable fiscal position and is unlikely to encounter hardships.
Various assets may be considered relevant, depending on the analyst. Some say only cash and cash equivalents count as relevant assets because short-term liabilities will probably be paid in cash. For others, debtors and trade receivables should qualify as relevant, while yet others consider the value of inventory relevant in liquidity ratio calculations.
The cash cycle is another vital concept to study for those who seek a greater understanding of liquidity ratios. Cash normally moves around a company’s operations and is tied up until the inventory is sold and the company receives the payment in cash. But until that payment is made, the money going around in the cash cycle is called working capital, where liquidity ratios are metrics that determine the balance between the company’s current assets and current liabilities.
Before a company can meet its financial obligations, it must first extract cash from the cash cycle so that creditors can be paid. In short, a company should have the capacity to convert its short-term assets into cash. That’s exactly what liquidity ratios attempt to assess.
List of liquidity ratios
Below is the complete list of liquidity ratios we have covered. Each will provide a detailed overview of the ratio, what it’s used for, and why.
They also explain the formula behind the ratio and provide examples and analysis to help you understand them.
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- Adjusting EntriesAdjusting entries are journal entries (which is why they are sometimes called adjusting journal entries) that are made at the end of the financial reporting period to correct the accounts for the preparation of financial statements.
- Annual IncomeDefinition: Income is money (or some equivalent value) that an individual or business gets, usually in exchange through investing capital or providing a good or service.
- Annual Percentage YieldThe annual percentage yield (APY) helps a business or investor to understand how much they are earning from the money they have invested with compounded interest.
- Annuity PaymentAn annuity is a financial product that pays out a series of cash flows at a specified frequency and over a fixed time period.
- Annuity Payment from Future Value (FV)Annuity payment from future value is a formula that helps one to determine the value of cash flows in an annuity when the future value of the annuity is known.
- Asset AccountsAn asset account is a category within a company’s general ledger account that shows the value of the assets it owns.
- Asset Coverage RatioThe asset coverage ratio determines a company’s capacity to pay its debt through its assets.
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- Asset Purchase AgreementAsset purchase refers to the process involved in the buying of a company’s assets.
- Asset TurnoverThe asset turnover ratio is a way to measure the value of a company’s sales compared to the value of the company’s assets.
- AVCO MethodThe Average Cost Method, also commonly referred to as the AVCO method, is a method used to find the average cost of items recorded in an inventory.
- Average Collection PeriodThe average collection period is an estimation of the average time period needed for a business to receive payment for money owed to them.
- Average Inventory PeriodAverage inventory period refers to a financial ratio used to compute the average number of days a company takes before they sell all their current stock of inventory.
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- Capital Intensity RatioCapital intensity ratio (CIR) is a metric that shows you how much capital is needed to generate $1 of revenue.
- Capital Lease AccountingCapital lease accounting refers to the accounting treatment of assets leased by a business under a capital lease agreement.
- Capital ResourcesCapital resources are the man-made assets employed in the manufacturing of further goods.
- Capitalization RatioThe capitalization ratio, also referred to as the cap ratio, is an indicator that measures the ratio between a company’s debts within its capital structure—the combination of debts and equities.
- Cash Conversion Cycle (CCC)The cash conversion cycle (CCC) is a measure of time indicated in days needed to convert inventory investments and other resources into sales-derived cash flow.
- Cash Earnings Per Share (Cash EPS)Cash earnings per share (Cash EPS) is a profitability ratio that compares a company’s cash flow against their volume of shares outstanding.
- Cash Flow Adequacy RatioThe cash flow adequacy ratio is used to determine if the cash flow generated by a company is sufficient to pay for its ongoing expenses—for example, reductions in long-term debt, acquisition of fixed assets or paying dividends to shareholders.
- Cash Flow Coverage RatioThe cash flow coverage ratio represents the relationship between a company’s operating cash flow and its total debt.
- Cash Flow Statement – Direct MethodA statement of cash flows can be prepared by either using a direct method or an indirect method.
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- Cash Flow to Debt RatioThe cash flow to debt ratio is a coverage ratio that reflects the relationship between a company’s operational cash flow and its total debt.
- Cash Flow to Sales RatioCash Flow to Sales Ratio is a performance metric that represents a business’s operating cash flow once all capital expenditures related to sales have been deducted.
- Cash RatioThe cash ratio (also known as the cash coverage ratio) is a measurement of how well can the company pay its short-term debt in the form of cash and cash equivalent (investment items that immediately available to be turned into cash e.
- Cash Reinvestment RatioThe cash reinvestment ratio, also known as the cash flow reinvestment ratio, is a valuation ratio used to measure the percentage of annual cash flow that the company invests back into the business as a new investment.
- Cash Return On Assets RatioThe cash return on assets (cash ROA) ratio is a measure of the operational cash flow against the total assets owned by a business.
- Cash SalesA cash sale is a business transaction in which the buyer pays for goods or services at the time of the purchase.
- Cash to Current Assets RatioCash to current assets is a liquidity ratio that measures how much of the current assets in a company are made up of cash and cash equivalents.
- Cash to Current Liabilities RatioCash to current liabilities ratio, also known as the cash ratio, is a cash flow measure that compares the firm’s most liquid assets to its short-term obligations.
- Cash to Working Capital RatioThe cash to working capital ratio measures what percentage of the company’s working capital is made up of cash and cash equivalents such as marketable securities.
- Cash Turnover Ratio (CTR)The cash turnover ratio (CTR) a profitability and efficiency ratio that measures how many times a company uses its cash to generate revenues.
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- Current RatioCurrent ratio determines the ability of a company or business to clear its short-term debts using its current assets.
- Current YieldThe current yield is the return that an investor would receive, based on a current rate.
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- Days Cash on HandDays cash on hand is the number of days a company can keep up with its operating expenses using the cash available in the business.
- Days Payable Outstanding (DPO)Days payable outstanding (DPO) is a ratio measuring the average time a company takes to pay its invoices & bills to suppliers and vendors.
Advantages and disadvantages
Analysts can rely on liquidity ratios to quickly assess several companies at once for potential issues. They help creditors determine whether or not a company can cover short-term liabilities and the level of risk they carry when seeking new debt. By comparing ratios within a single industry, analysts improve their understanding of a company’s fiscal strength with respect to those of its competitors.
Liquidity ratios, while generally useful, are not perfect metrics. They are calculated using values found in the company’s balance sheet, which means they capture a moment in the past but can’t be taken as a predictor of future performance. They can also be a the outcome of brilliant accounting strategies. A good analyst, however, will not only analyze the numbers themselves, but also every item of the balance sheet under current assets and current liabilities.