Liquidity is a measure of how quickly a firm is able to convert its assets into cash. While analyzing the liquidity position of a company, an analyst uses the common liquidity ratios to measure the company’s ability to pay-off its short-term liabilities.
There are four important liquidity ratios:
- Current Ratio
- Quick Ratio
- Cash Ratio
- Defensive Interval Ratio
All these ratios compare the company’s short-term assets with its short-term liabilities, however, make use of short-term assets with varying levels of liquidity.
We will take a simple example to understand these ratios. Let’s say that we have the following data for a company.
|Current Assets||Current Liabilities|
Total Current Liabilities
|Short-term Marketable Securities||$20,000|
|Total Current Assets||$140,000||$110,000|
Let’s calculate the liquidity ratios using this data.
The current assets include all the current assets that we expect to convert to cash in one year.
Current ratio = $140,000/$110,000 = 1.273
A high current ratio indicates that the company has good liquidity to meet its short-term obligations. If this ratio is low, this means that the company has low liquidity and is relying on its operating cash flow and loans to meet its obligations.
One problem with this ratio is that it assumes that the inventory and account receivables are liquid.
Quick ratio is the same as current ratio except that it excludes inventory from the current assets. It assumes that inventory cannot be easily converted into cash and hence is excluded from the liquid assets.
The quick assets include only cash and cash equivalents, short-term investments, and account receivables. It excludes inventory, and other current assets, which are not liquid such as prepaid expenses, deferred income tax, etc.
Quick ratio = $100,000/$110,000 = 0.91
This ratio is considered a superior measure to the current ratio. A high quick ratio indicates that the company has good liquidity to meet its short-term obligations.
This ratio takes an even more conservative measure to liquidity, and includes only cash, cash equivalents and short-term investments as liquid assets.
The assets include only cash and cash equivalents, and short-term investments. It excludes inventory, account receivables and any other current assets.
Cash ratio = $40,000/$110,000 = 0.36
This ratio is not commonly used, but is useful in a crisis situation. Even in a crisis situation this ratio may not be reliable because the value of marketable securities can change drastically.
Defense Interval Ratio
This ratio measures for how many days can a company pay its daily expenses only from the existing liquid assets assuming that the company does not receive any new cash flow. This ratio considers only quick assets for the purpose of existing liquid assets.
Assuming that in our example the company has daily cash expenses of $2,000, the ratio will be calculated as follows:
Defense interval ratio = $100,000/$2,000 = 50 days.
This indicates that the company can continue to meet its daily cash expenses for 50 days from the existing liquid assets. A high ratio indicates that the company is quite liquid. A low ratio is a cause of concern and the analyst need to look into whether the company is expecting stronger cash inflows.