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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- Asset Coverage RatioThe asset coverage ratio determines a company’s capacity to pay its debt through its 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.
- 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.
- Average Payment Period (APP)Average payment period (APP) is a metric that allows a business to see how long it takes on average to pay its vendors.
- Balance SheetThe balance sheet is one of the general-purpose financial statements prepared during the accounting cycle.
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- 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 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 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.
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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.
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- Days Working CapitalDays working capital is a measurement that reports the number of days it takes for the working capital to be converted into revenue.
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- Debt RatioDebt ratio is a measurement that indicates how much leverage a company uses to finance its operation by using debt instead of its truly owned capital or equity.
- Debt Service Coverage RatioThe debt coverage ratio is used to determine whether or not a company can turn enough of a profit to cover all of its debt.
- Debt Service Coverage Ratio (DSCR) Excel TemplateThe debt coverage ratio is used to determine whether or not a company can turn enough of a profit to cover all of its debt.
- Debt to Asset RatioDebt to asset, also known as total debt to total asset, is a ratio that indicates how much leverage a company can use by comparing its total debts to its total assets.
- Debt to Capital RatioThe debt to capital ratio is a ratio that indicates how leveraged a company is by dividing its interest-bearing debt with its total capital.
- Debt to EBITDA RatioThe debt to EBITDA ratio is a leverage metric that measures the amount of income that is available to pay down debt before covering interest, taxes, depreciation, and amortization expenses.
- Debt to EquityDebt to equity is a financial liquidity ratio that measures the total debt of a company with the total shareholders’ equity.
- Debt to Income Ratio (DTI)Debt to income (DTI) is a ratio measuring an individual’s ability to pay their debts.
- Debt to Net Worth RatioThe debt to net worth ratio is a financial metric used in comparing the level of debt of a company with its net worth.
- Defensive Interval Ratio (DIR)Defensive interval ratio (DIR), also known as the defensive interval period (DIP) or basic defense interval (BDI), determines how many days a company can keep operating.
- DepreciationDepreciation is the cost that is allocated to a fixed asset over its useful life.
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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.