Liquidity ratios are a group of ratios created to measure the ability of a business operation to meets its current obligations. Liquidity ratios are similar to the initial medical tests a patient receives at a doctor’s visit. Doctors take blood pressure, temperature, and pulse rate. The doctor wants assurance that the primary indicators of health are good. Liquidity ratios are exactly the same. The user wants to know that the basic measurements of a business indicate good health today.
Liquidity ratios identify various time periods of liquidity. From the longer operating cash ratio down to the immediate cash ratio, there are four ratios in this group. Many novice businessmen mistakenly place too much emphasis on this set of ratios in their decision models. The simple truth is that liquidity ratios are easily manipulated and sophisticated business reviewers understand this and apply the ratios appropriately. This article will help the reader understand how to properly apply the ratios and interpret the information.
The four liquidity ratios are:
This article will explain the four liquidity ratios individually and finish by revealing the proper application of this group of ratios with various decision models.
Operating Cash Ratio
The operating cash ratio is the most complicated ratio of all the business ratios. This is because the user must understand how to derive cash earnings from normal operations. In effect, it is equal to the cash flow from operations part of the cash flows report. This cash earnings is the numerator in the formula used to determine how frequently, i.e. turns, the cash can pay current liabilities. The greater the ratio, the more liquidity exists.
The formula is:
Operating Cash Ratio = Cash Flow From Operations
The formula does have a built-in flaw related to using the change in current liabilities to calculate cash flow from operations. To adjust for this, sophisticated users of this formula use the current liabilities beginning balance, not the ending balance. A second drawback is a negative cash flow from operations. The equation is impossible to solve with negative cash flow.
It is important for the reader to understand, although this formula is complex, it is the best overall indicator of liquidity. Why? The operating cash ratio reflects the ability to pay current liabilities from cash generated by operations. It is the complete picture. The other liquidity ratios are limited to the actual current assets on the books and not cash sourced from operations. Another interesting perspective is that the operating cash flow ratio is more stable because the business is utilizing an entire accounting cycle to determine liquidity. Simply stated, the operating cash ratio is the broadest of the liquidity ratios and should be given the greatest weight in a decision model about liquidity. If there is one ratio you truly want to understand and appreciate, this is the one.
The other liquidity ratios are narrower in scope.
The current ratio is the simplest of all the business ratios. It is inherently flawed and therefore unreliable. The current ratio formula relates to the respective accounting cycle due to the formula:
Current Ratio = Current Assets
It is all-inclusive of current assets and current liabilities. Since both groups of balance sheet items include relatively short-term items such as cash and accounts payable along (immediate and 30 day accounts respectively) with other items that are much longer in time impact such as prepaid expenses and current portion of long-term debt, the ratio reflects a mix of fiscal year information. Many different cash changes can happen within one year, thus this ratio is merely a point in time along that one year spectrum. A sophisticated user of business ratios will use a line graph of the ratio over the entire year to understand the ratio’s true value and corresponding impact.
Examples of items that can easily affect the current ratio in the short-term include, borrowing money with a line of credit, cash infusion from non operating activities (sale of a fixed asset, sale of stock etc.) and cash disbursements for dividends. Here is a simple example.
XYZ Company has $250,000 of current assets and $120,000 of current liabilities. It is a seasonal company and is ramping up activities for the new season. XYZ Company exercises its line of credit for $200,000 to begin purchasing additional inventory. The before and after ratios are as follows:
Current Ratio = $250,000 of Current Assets = 2.0833:1
$120,0000 of Current Liabilities
Current Ratio = $450,000 of Current Assets = 1.4605:1
$320,000 of Current Liabilities
Note the significant decrease in the ratio which would have the common entrepreneur think twice about this change. However, a line graph of the ratio over a period of one year (minimum should be around 3 years) will provide a better understanding of XYZ’s ability to pay its current obligations as a result of this ratio.
The keys to this ratio are:
- It is simple and broad in scope,
- There are too many possibilities to influence the ratio thus making it unreliable, AND
- The ratio should only be evaluated as a line graph over an extended period of time (3 years minimum).
It is better to use a more focused liquidity ratio.
The quick ratio is much narrower in scope and time as compared to the current ratio. This ratio is often referred to as the ‘Acid Test’ ratio. The acid test refers to the old system of testing gold by placing a drop of acid on the element. The color change would tell the buyer of gold its purity and thus the value. Here, this is somewhat similar for liquidity. To make current assets purer, the user drops out of the equation the one current asset that will take time to liquidate, inventory.
Inventory turnover can be short-term such as food or long-term such as construction in process. By dropping out inventory in the formula, the user doesn’t have to concern the ending value related to the inventory sale. Thus, the quick ratio removes time as the primary detriment to a result. The formula is exactly like the current ratio except it remove’s inventory from the numerator.
Quick Ratio = Current Assets Less Inventory
This ratio is flawed too. Notice how nothing changes with current liabilities even though some portion of those liabilities are tied to the inventory, e.g. supplier accounts payable. Worse, those companies with a high reliance on financing inventory, such as contractors, seasonal sellers, big-ticket sellers (appliances, furniture, auto dealerships etc.); this ratio can get lopsided. As an example, look at this RV Dealership’s current ratio and quick ratio based on the balance sheet.
Sub-Total Current Assets $5,300,000
Accounts Payable $300,000
Floor Plan 3,600,000
Sub-Total Current Liabilities $4,100,000
The current ratio is 1.29:1. The quick ratio is:
Quick Ratio = Current Assets less Inventory = $1,300,000 = .317:1
Current Liabilities $4,100,000
This ratio is valuable if used with the correct industry or industries. As with the current ratio, use a line graph over an extended period of time to evaluate improvement. As with all ratios, comparing several periods of time is best when evaluating the ability to pay current obligations.
Some users of liquidity ratios want an immediate understanding of the ability to pay current liabilities. The user wants to know about today only. There is one liquidity ratio that is highly narrow in its focus, that is the cash ratio.
The cash ratio is very narrow in time period utility. It reflects the ability to pay current obligations today, right now, not tomorrow or the next day or even 30 days from now. Today.
This ratio takes all cash as the only asset with the ability to pay current obligations. It is extremely pure as it relates to liquidity. Its formula is really simple:
Cash Ratio = Cash
For most businesses, it is never greater than 1 to 1. The more cash intensive the operation, such as restaurants, salons and banking, the higher the ratio’s outcome. With the food service industry, it should always be greater than 1:1. As the entity operations shift towards fixed assets reliance, the less likely this ratio will exceed 1:1.
As a liquidity ratio, it has a purpose. It is more useful to the owners than an outsider interpreter of information. For the owner, the ratio sets a minimum threshold to stay above in order to maintain solvency. It can also identify trigger points for distributions and dividends.
If you are using this ratio as a potential investor with this business, take into consideration several factors before relying on this ratio. Consider:
- The sector and particular industry,
- Industry standards,
- Sources of cash and ability to obtain cash at a moment’s notice,
- The other liquidity ratios.
Proper Application of Liquidity Ratios
Proper application of liquidity ratios helps the user to understand the operations current solvency status and the ability to maintain solvency in the near future. Liquidity ratios should never be used to predict the ability to pay obligations beyond a 30 day window.
All the ratios have inherent flaws, the most obvious is the ability to add to or subtract from current assets without affecting current liabilities. Long-term borrowings, infusion from the owners or the sale of fixed/other assets can cause spikes (upward or downward) with all four liquidity ratios.
Proper application of the liquidity ratios include:
- Utilizing line graphs over an extended period of time for all four of the liquidity ratios. Three years of information is the minimum time period a user needs to evaluate the respective ratio.
- The order of credit-ability of the ratios is as follows:
- Operating cash ratio adjusted to beginning current liabilities
- Current ratio
- Quick ratio
- Cash ratio
- Give the operating cash ratio the greatest weight factor when using liquidity ratios.
- Identify the ability of the company to infuse cash from non-operating sources such as loans, owner contributions, sales of fixed assets etc.
- Never make a decision solely based on liquidity ratios.
- Liquidity ratios are designed to measure solvency and not bankruptcy; liquidity ratios can only measure the ability to meet obligations in the near future, i.e. 30 days or less.
- Economic sectors and their corresponding industries have their own respective standards to gauge liquidity ratios against, use the standards from a comparative industry when evaluating results. If there are no standards available, use a long time line of the ratio’s change. There should be continuous improvement.
The key for the user is to look at the ratios as an immediate indicator of financial health. Just as a doctor performs an initial batch of tests on a patient to gauge any immediate concern, users of ratios turn to liquidity ratios to gauge solvency of the business. Use other ratios to determine the long-term success of a business. Liquidity ratios should not have a lot of weight with a business decision model. Use liquidity ratios with at least a dozen other ratios to evaluate a business operation. ACT ON KNOWLEDGE.