What's a good liquidity ratio for your business?

Liquidity ratios are like an electric battery powering your car. These ratios show how much power (liquid assets) you have available to keep the engine running and reach your next destination or for a company’s ability to meet its short-term obligations. Just as you need enough charge on the battery to keep moving forward, a company needs enough working capital to operate efficiently without disruptions.

Liquidity or working capital ratios help assess if there are sufficient current assets available to cover current liabilities. High liquidity ratios indicate your business can pay its expenses and debts through its profits.

Whereas a low liquidity ratio may indicate a debt or cash flow problem—which you may decide to tackle by reviewing your financing, ramping up pressure on past-due accounts receivable, and negotiating longer pay cycles for your own accounts payable.

What are the types of liquidity ratios?

Operating cash flow ratio: Is a measure of how many times an organization can cover its current liabilities from cash flows generated from operating activities. An alternative ratio formula is to use your earnings before interest, taxes, depreciation, and amortization (EBITDA), an approximation for operating cashflow to measure how well the business covers liabilities.

Current ratio: Measures your organization’s ability to pay short-term obligations, usually over the next 12 months. The current ratio is calculated by dividing current assets by current liabilities. One of the limitations of the current ratio is that it can include less liquid assets such as inventory which is why many organizations prefer to use the quick ratio.

Quick ratio: (also known as the acid-test ratio): Evaluates the amount of liquid (quick) assets available to cover liabilities, indicates short-term liquidity. Generally, the acid test ratio should be 1:1 or higher; however, this varies by industry.  In general, the higher the ratio, the greater the company's liquidity (i.e. the better able to meet current obligations using liquid assets).

Cash ratio: Calculates ability to repay short-term debt with cash resources and cash equivalents (such as savings accounts and short term investments like mutual funds or treasury bills).

Asset ratio: to calculate take total liabilities divided by total assets of a company. It measures the proportion of a company's assets that are financed by debt.

Liquidity ratios vs. solvency ratios.

Compared to liquidity Ratios, solvency ratios, also know as leverage ratios, better indicate a company’s overall valuation, creditworthiness and ability to cover long-term debt obligations and total current liabilities.

Solvency ratios include debt-to-interest, interest coverage and the debt-to-equity ratio.

How do liquidity ratios help with decision-making?

When lenders extend credit to your organization, they typically analyze your liquidity ratio to determine the likelihood of repayment. Good liquidity ratios indicate that a company can comfortably meet its short-term debt obligations without financial strain.

What is considered a good liquidity ratio?

A current ratio of 1.5 to 2 is generally considered good. This means the company has $1.50 to $2 of current assets for every $1 of current liabilities. A ratio below 1 suggests potential liquidity issues, as the company may not have enough assets to cover short-term debts.

A quick ratio of 1 or higher is typically considered good. This means the company has at least $1 in highly liquid assets (cash, marketable securities, accounts receivable) for every $1 of current liabilities. A ratio below 1 might suggest that the company could struggle to cover immediate liabilities without selling inventory or other less-liquid assets.

Since liquidity ratios can reveal whether the organization has sufficient funds to meet obligations, they can be an extremely useful tool for determining a company’s financial health. Procurement teams can use these liquidity ratios to determine whether suppliers can supply stock before placing an order. They can also weigh up whether a company has enough cash to fulfil a contract.

Who can benefit from using liquidity ratios?

If you have a product or stock-driven business, liquidity ratios are powerful metrics to watch in combination with debtor days and stock turn.

As with any financial ratio, observing the trends is important to maintain financial stability. If the liquidity ratios are frequently changing or trending downward over time, discussions need to take place cross-functionally to fix the issues.

Best ways to use most common liquidity ratios

When you use liquidity ratios effectively, you can quickly diagnose cash flow issues or a trend in debt problems, which can be particularly relevant for stock-driven businesses. A liquidity ratio above 1 indicates that your company has enough net working capital to cover its current bills.

Calculating liquidity ratios using an excel spreadsheet can be a time-consuming manual exercise. A BI and FP&A platform, with built-in financial statements software, enables your team to quickly pull the relevant data and automate the calculation of liquidity ratios within the company’s balance sheet. You can then track these financial metrics over time and drill down into the relevant data to determine where the problems lie.

Liquidity ratios vary by industry

Liquidity ratio ranges vary by industry, so it's essential to compare your liquidity position to industry averages. Publicly traded companies often publish their current ratio in annual financial statements, so are easy to find and compare. Certain industries, like retail or manufacturing, may have lower liquidity ratios due to the nature of holding stock, while industries like healthcare and financial services can have higher liquidity ratios due to stronger cash positions and fewer short-term liabilities.

Using the Phocas Financial Statements software you can also quickly create a profit and loss statement for each division and add liquidity ratios so you always know the company’s short term financial obligations are covered.