Liquidity ratios are able to tell us quite a bit about the financial health of a company. Both corporations and individuals use liquidity ratios on the regular to understand what their current risk level is at a particular point in time. In turn, this affects their business outlook for the near future.
In this article, we are going to look at some of the main liquidity ratios that are commonly used to determine what they can tell us about a company. Furthermore, we will discuss how to calculate them so that you can put them into practice.
What Are Liquidity Ratios
Liquidity is defined in business as the measure of how capable a firm is of paying its debts and staying operational. Generally speaking, it is the measure of how much cash a firm has versus how much debt the company has. When you decide to measure these one against the other, this action produces a ratio. For example, if a firm has $1 million in cash, but it has $500,000 in debt, you could say that the firm has a cash liquidity ratio of 2:1, or just “2”.
A firm always wants its various liquidity ratios to be higher than 1, because this means that they are able to stay afloat. Any ratio that comes in at less than 1 is an indicator that a firm has more debt than assets, which does not bode well for its future business operations.
Who Uses Liquidity Ratios?
Liquidity ratios are most commonly used by large corporations. Each quarter, these corporations will update a form known as a 10-Q which details their financial performance to the public. This form is required by the Securities and Exchange Commission (SEC) in order to make sure that investors are fully informed about the stability of the company. In turn, the height or depth of these liquidity ratios will play into determining that company’s stock price.
Of course, regular individuals who own their own business(es) can use liquidity ratios as well to help them determine the extent to which they should reasonably take on more debt. While debt is very useful for expansion purposes, taking on too much can lead to a company’s capital structure becoming over-weighted. For the typical business-owner, it is best to have a general liquidity ratio higher than 2.
Ways in Which Liquidity Ratios Can Help Your Business
Now, while it is privy for a business owner to have a “general liquidity ratio” higher than 2, we understand that this is not always possible. For this reason, it is important that we talk about a couple of the different types of liquidity ratios that exist:
- Acid-Test Ratio: This measures whether or not a firm can sell all of its marketable securities, obtain their accounts receivable, and use their remaining cash to immediately get rid of all of their debt.
- Current Ratio: This measures whether or not all of a firms’ current assets can cover their current liabilities (debts) within the next 12 months.
- Cash Ratio: This ratio measures if a firm can pay all of its liabilities with cash only.
If you are a business owner, think of these ratios as a progression/goals system. Your first goal should be to get your acid-test ratio higher than 1. This is a measure of solvency (i.e. can the business survive?). Next, you should attempt to get your current ratio higher than 1. That means that you can survive at least the next year and are fairly stable. Finally, a cash ratio over 1 is a superior company position because it means that you have so much immediately available cash that it outweighs all of your debts.
4 Tips for Liquidity Ratios
Here are some points to think about when dealing with liquidity ratios:
- Account for Your Business Needs: Before you consider starting a business, or perhaps making an expansion with your current business, take a look at where you stand with your liquidity ratios. If they aren’t in good proportion, consider looking at ways that you can cut costs or increase your assets before you make a move. The peace of mind that comes with being highly solvent is worth far more than the potential growth that you can experience from taking on added risk.
- Hire a Good CPA: Liquidity ratios aren’t incredibly easy to calculate. This is because it is difficult to get a true snapshot of where your business stands with assets versus liabilities at any given point in time. However, by allowing a CPA to oversee your company and set up a Quickbooks profile, he or she can easily calculate these ratios for you and dictate to you where you stand on a quarterly basis.
- Liquidity Doesn’t Exist in a Vacuum: Make sure that you aren’t only looking at liquidity ratios by themselves. Instead, stay up to date on your company’s operating cash flows, investments, and other statistics, as these will directly dictate whether your liquidity ratios improve or worsen. To learn more, you can search these terms on Investopedia.
- Check Corporate Investments Often: If you own investments in the common stocks of different companies, make sure that you check their liquidity ratios at least once semi-annually. These translate to the level of risk that a company is taking on, which will impact how much their debt costs to finance. If the company is taking on too much debt relative to their assets, you may want to dump the stock.
Putting it All Together
Jointly, the different liquidity ratios that are possible to calculate serve as a good indicator of the risk level of a business at a specific point in time. By calculating these ratios regularly, both for a business that you own and with investments that you own, you will be more likely to succeed financially.
I would encourage you, if you haven’t already, to consider becoming a client of a trustworthy CPA who can teach you more about liquidity ratios and other things that can help you understand how to better operate your business.
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