Liquidity ratio and why it’s important

If you come across the term liquidity ratio, you might think it’s just a technical accounting term. In fact, it’s a financial measure that provides you with an important indication of the financial health of your business.

Your liquidity ratio tells you whether you have the ability to meet your upcoming liabilities. Typically, this means you have sufficient cash, bank deposits or assets that can quickly be converted to cash to pay your bills. If you don’t, your business could hit difficulties and could even be forced to cease trading.

That’s a simple view of the liquidity ratio, so in this article, we’ll go deeper into the ways you can calculate and analyse your ratio. This is just as important for new businesses planning their finances as established firms looking to improve their financial control.

Assets and liabilities

The key elements of the liquidity ratio are assets and liabilities.  Assets are what you own and use to run your business. They might include property, stock, machinery and equipment, as well as cash, bank deposits, loans, grants, overdrafts and receivables – the amounts your customers owe on the invoice. Liabilities are what you owe to banks, suppliers, tax authorities or other creditors.

That’s simple enough, but the problem is that not all assets are liquid — they cannot be quickly converted to cash. Property, machinery and equipment are the least liquid and stock may not sell quickly enough to meet demands.

So taking the ‘illiquid assets’ out of the equation, leaves your liquid assets to factor into the liquidity ratio.

Calculating your liquidity ratio

There are a number of different liquidity ratios, including the current ratio, quick ratio and cash ratio.

Current ratio

This is also known as the working capital ratio and indicates your ability to pay short-term liabilities payable within 12 months from current assets such as cash or cash equivalents, receivables and short-term deposits.

The formula for calculating the current ratio is:

Current ratio = Current assets/Current liabilities

If you have current assets of £120,000 and current liabilities of £60,000 your current ratio would be 2:1 and you would be in a position to cover your liabilities. However, if the ratio was 1:1 or lower, you could face short-term problems in meeting your debts.

Quick ratio

The quick ratio or ‘acid test ratio’ measures your ability to pay off your current liabilities with assets that can be converted into cash within 90 days. That limits the assets you can use in the calculation, so the calculation would normally exclude your stock, but would include cash or cash equivalents, receivables due for settlement within 90 days and short-term deposits that could be released within the period.

The formula for calculating the quick ratio is:

Quick ratio = Cash or cash equivalents + Current receivables + Short-term deposits/Current liabilities

Like the current ratio, a quick ratio of 2:1 or higher puts you in a position to meet your liabilities, but a ratio of 1:1 or lower indicates risk.

Cash ratio

This is the ratio of cash and cash equivalents to total liabilities. As well as giving you an indication of the financial health of your business, this ratio is also used by lenders and suppliers to measure your ability to repay your debts.

The formula for calculating the current ratio is:

Cash ratio = Cash + cash equivalents /Current liabilities

If the cash ratio is above 1, you have the ability to meet your current debts and retain cash for other uses. Below 1, you will not be able to meet your current liabilities.

Example of liquidity ratio

To calculate the various ratios, bring all your figures for assets and liabilities together in a table similar to the example below.

You can then carry out the calculations based on those figures.

Current ratio = Current assets/Current liabilities

Current ratio = 9550/5900 = 1.62

Quick ratio = Cash or cash equivalents + Current receivables + Short-term deposits/Current liabilities

Quick ratio = 4550/5900 = 0.77

Cash ratio = Cash + Cash equivalent/Current liabilities

Cash ratio = 3000/5900 = 0.51

Significance of the liquidity ratio

The ratios provide a useful guide to the current financial health of your business, but you should look closely at the figures and use them as a basis for financial planning for the future.

It’s important to put the ratios in context. If you have a ratio that indicates you can meet your liabilities comfortably, are you making the best use of your assets?  For example, if you have a very high ratio of assets to liabilities, you could be making more productive use of the ‘spare cash’ to invest in the growth of your business.

Similarly, if the reason behind the higher ratio is increasing stock levels or receivables, this could indicate a stock that is not selling quickly or poor credit control. Both could indicate future problems.

It can be useful to compare your ratios with those of competitors or the industry average to provide a benchmark for analysis. For current ratios, for example, a figure of 1.5:1 is regarded as acceptable.

If your ratios are below a safe level, you need to take action quickly to reduce risk. You might aim to reduce your outgoings, improve credit control to turn receivables into cash or consider a loan to access additional funding.

Read More: How To Read A Company Balance Sheet

Accounts and Legal can help

Understanding your liquidity position is important, but it’s not something every business is up to scratch on. Our team of small business accountants are highly-experienced in helping firms with the preparation and analysis of liquidity ratios.

Get in touch with us today for further advice on 0207 043 4000 or info@accountsandlegal.co.uk. You can also get an instant accounting quote.