Which of the following ratios would be useful in assessing short-term liquidity?

A common use of financial ratios is when a lender determines the stability and health of your business by looking at your balance sheet. The balance sheet provides a portrait of what your company owns or is owed (assets) and what it owes (liabilities). Bankers will often make financial ratios a part of your business loan agreement. For instance, you may have to keep your equity above a certain percentage of your debt, or your current assets above a certain percentage of your current liabilities.

But ratios should not be evaluated only when visiting your banker. Ideally, you should review your ratios on a monthly basis to keep on top of changing trends in your company. Although there are different terms for different ratios, they fall into 4 basic categories.

Liquidity ratios

These measure the amount of liquidity (cash and easily converted assets) that you have to cover your debts, and provide a broad overview of your financial health.

The current ratio measures your company's ability to generate cash to meet your short-term financial commitments. Also called the working capital ratio, it is calculated by dividing your current assets—such as cash, inventory and receivables—by your current liabilities, such as line of credit balance, payables and current portion of long-term debts.

The quick ratio measures your ability to access cash quickly to support immediate demands. Also known as the acid test, the quick ratio divides current assets (excluding inventory) by current liabilities (excluding current portion of long-term debts). A ratio of 1.0 or greater is generally acceptable, but this can vary depending on your industry.

A comparatively low ratio can mean that your company might have difficulty meeting your obligations and may not be able to take advantage of opportunities that require quick cash. Paying off your liabilities can improve this ratio; you may want to delay purchases or consider long-term borrowing to repay short-term debt. You may also want to review your credit policies with clients and possibly adjust them to collect receivables more quickly.

A higher ratio may mean that your capital is being underutilized and could prompt you to invest more of your capital in projects that drive growth, such as innovation, product or service development, R&D or international marketing.

But what constitutes a healthy ratio varies from industry to industry. For example, a clothing store will have goods that quickly lose value because of changing fashion trends. Still, these goods are easily liquidated and have high turnover. As a result, small amounts of money continuously come in and go out, and in a worst-case scenario liquidation is relatively simple. This company could easily function with a current ratio close to 1.0.

On the other hand, an airplane manufacturer has high-value, non-perishable assets such as work-in-progress inventory, as well as extended receivable terms. Businesses like these need carefully planned payment terms with customers; the current ratio should be much higher to allow for coverage of short-term liabilities.

Efficiency ratios

Often measured over a 3- to 5-year period, these give additional insight into areas of your business such as collections, cash flow and operational results.

Inventory turnover looks at how long it takes for inventory to be sold and replaced during the year. It is calculated by dividing total purchases by average inventory in a given period. For most inventory-reliant companies, this can be a make-or-break factor for success. After all, the longer the inventory sits on your shelves, the more it costs.

Assessing your inventory turnover is important because gross profit is earned each time such turnover occurs. This ratio can enable you to see where you might improve your buying practices and inventory management. For example, you could analyze your purchasing patterns as well as your clients to determine ways to minimize the amount of inventory on hand. You might want to turn some of the obsolete inventory into cash by selling it off at a discount to specific clients. This ratio can also help you see if your levels are too low and you're missing out on sales opportunities.

Inventory to net working capital ratio can determine if you have too much of your working capital tied up in inventory. It is calculated by dividing inventory by total current assets. In general, the lower the ratio, the better. Improving this ratio will allow you to invest more working capital in growth-driven projects such as export development, R&D and marketing.

Evaluating inventory ratios depends a great deal on your industry and the quality of your inventory. Ask yourself: Are your goods seasonal (such as ski equipment), perishable (food) or prone to becoming obsolete (fashion)? Depending on the answer, these ratios will vary a great deal. Still, regardless of the industry, inventory ratios can you help you improve your business efficiency.

Average collection period looks at the average number of days customers take to pay for your products or services. It is calculated by dividing receivables by total sales and multiplying by 365. To improve how quickly you collect payments, you may want to establish clearer credit policies and set collection procedures. For example, to encourage your clients to pay on time, you can give them incentives or discounts. You should also compare your policies to those of your industry to ensure you remain competitive.

Profitability ratios

These ratios are used not only to evaluate the financial viability of your business, but are essential in comparing your business to others in your industry. You can also look for trends in your company by comparing the ratios over a certain number of years.

Net profit margin measures how much a company earns (usually after taxes) relative to its sales. A company with a higher profit margin than its competitor is usually more efficient, flexible and able to take on new opportunities.

Operating profit margin, also known as coverage ratio, measures earnings before interest and taxes. The results can be quite different from the net profit margin due to the impact of interest and tax expenses. By analyzing this margin, you can better assess your ability to expand your business through additional debt or other investments.

Return on assets (ROA) ratio tells how well management is utilizing the company's various resources (assets). It is calculated by dividing net profit (before taxes) by total assets. The number will vary widely across different industries. Capital-intensive industries such as railways will yield a low return on assets, since they need expensive infrastructure to do business. Service-based operations such as consulting firms will have a high ROA, as they require minimal hard assets to operate.

Return on equity (ROE) measures how well the business is doing in relation to the investment made by its shareholders. It tells the shareholders how much the company is earning for each of their invested dollars. It is calculated by dividing a company’s earnings after taxes (EAT) by the total shareholders’ equity, and multiplying the result by 100%.

A common analysis tool for profitability ratios is cross-sectional analysis, which compares ratios of several companies from the same industry. For instance, your business may have experienced a downturn in its net profit margin of 10% over the last 3 years, which may seem worrying. However, if your competitors have experienced an average downturn of 21%, your business is performing relatively well. Nonetheless, you will still need to analyze the underlying data to establish the cause of the downturn and create solutions for improvement.

Leverage ratios

These ratios provide an indication of the long-term solvency of a company and to what extent you are using long-term debt to support your business.

Debt-to-equity and debt-to-asset ratios are used by bankers to see how your assets are financed, whether it comes from creditors or your own investments, for example. In general, a bank will consider a lower ratio to be a good indicator of your ability to repay your debts or take on additional debt to support new opportunities.

Accessing and calculating ratios

To determine your ratios, you can use a variety of online tools such as BDC's ratio calculators, although your financial advisor, accountant and banker may already have the most currently used ratios on hand.

For a fee, industry-standard data is available from a variety of sources, both printed and online, including Dun & Bradstreet's Industry Norms and Key Business Ratios, RMA's Annual Statement Studies and Statistics Canada (search for Financial Performance Indicators for Canadian Business). Industry Canada's SME Benchmarking Tool offers basic financial ratios by industry, based on Statistics Canada small business profiles.

Interpreting your ratios

Ratios will vary from industry to industry and over time. Interpreting them requires knowledge of your business, your industry and the reasons for fluctuations. In this light, BDC experts offer sound advice, which can help you interpret and improve your financial performance.

Beyond the numbers

It's important to keep in mind that ratios are only one way to determine your financial performance. Beyond what industry a company is in, location can also be important. Regional differences in factors such as labor or shipping costs may also affect the result and the significance of a ratio. Sound financial analysis always entails closely examining the data used to establish the ratios as well as assessing the circumstances that generated the results.

Types of Liquidity Ratios

1. Current Ratio

Current Ratio = Current Assets / Current Liabilities

The current ratio is the simplest liquidity ratio to calculate and interpret. Anyone can easily find the current assets and current liabilities line items on a company’s balance sheet. Divide current assets by current liabilities, and you will arrive at the current ratio.

2. Quick Ratio

Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities

The quick ratio is a stricter test of liquidity than the current ratio. Both are similar in the sense that current assets is the numerator, and current liabilities is the denominator.

However, the quick ratio only considers certain current assets. It considers more liquid assets such as cash, accounts receivables, and marketable securities. It leaves out current assets such as inventory and prepaid expenses because the two are less liquid. So, the quick ratio is more of a true test of a company’s ability to cover its short-term obligations.

3. Cash Ratio

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

The cash ratio takes the test of liquidity even further. This ratio only considers a company’s most liquid assets – cash and marketable securities. They are the assets that are most readily available to a company to pay short-term obligations.

In terms of how strict the tests of liquidity are, you can view the current ratio, quick ratio, and cash ratio as easy, medium, and hard.

Important Notes

Since the three ratios vary by what is used in the numerator of the equation, an acceptable ratio will differ between the three. It is logical because the cash ratio only considers cash and marketable securities in the numerator, whereas the current ratio considers all current assets.

Therefore, an acceptable current ratio will be higher than an acceptable quick ratio. Both will be higher than an acceptable cash ratio. For example, a company may have a current ratio of 3.9, a quick ratio of 1.9, and a cash ratio of 0.94. All three may be considered healthy by analysts and investors, depending on the company.

Importance of Liquidity Ratios

1. Determine the ability to cover short-term obligations

Liquidity ratios are important to investors and creditors to determine if a company can cover their short-term obligations, and to what degree. A ratio of 1 is better than a ratio of less than 1, but it isn’t ideal.

Creditors and investors like to see higher liquidity ratios, such as 2 or 3. The higher the ratio is, the more likely a company is able to pay its short-term bills. A ratio of less than 1 means the company faces a negative working capital and can be experiencing a liquidity crisis.

2. Determine creditworthiness

Creditors analyze liquidity ratios when deciding whether or not they should extend credit to a company. They want to be sure that the company they lend to has the ability to pay them back. Any hint of financial instability may disqualify a company from obtaining loans.

3. Determine investment worthiness

For investors, they will analyze a company using liquidity ratios to ensure that a company is financially healthy and worthy of their investment. Working capital issues will put restraints on the rest of the business as well. A company needs to be able to pay its short-term bills with some leeway.

Low liquidity ratios raise a red flag, but “the higher, the better” is only true to a certain extent. At some point, investors will question why a company’s liquidity ratios are so high. Yes, a company with a liquidity ratio of 8.5 will be able to confidently pay its short-term bills, but investors may deem such a ratio excessive. An abnormally high ratio means the company holds a large amount of liquid assets.

For example, if a company’s cash ratio was 8.5, investors and analysts may consider that too high. The company holds too much cash on hand, which isn’t earning anything more than the interest the bank offers to hold their cash. It can be argued that the company should allocate the cash amount towards other initiatives and investments that can achieve a higher return.

With liquidity ratios, there is a balance between a company being able to safely cover its bills and improper capital allocation. Capital should be allocated in the best way to increase the value of the firm for shareholders.

More Resources

This has been CFI’s guide to Liquidity Ratio. To keep advancing your career, the additional CFI resources below will be useful: