How To Determine The Liquidity Of A Company

Liquidity shows the ability of a company to convert its assets to cash speedily. Here are some of the ratios used to determine that position in a company

Liquidity shows the ability of a company to convert its assets to cash speedily. Here are some of the ratios used to determine that position in a company.

Money can be quite tricky sometimes. A person might have so many assets and be categorized as wealthy but still have issues taking care of basic necessities. An example of this is how a person might have spent a lot of his money in amassing assets like properties.

However, when he is in need of money, he would have to struggle because those assets cannot be sold immediately for him to have actual money in his pocket.

This is a typical case of “what shall it profit a man to have all the assets in the world and have no actual cash to spend.” A company’s liquidity is its ability to meet its short-term financial obligations.

It could be to cover operations, to leverage opportunities as they arise, or to pay off its short-term debt obligations. For this to happen, the company needs to have assets that can easily converted to cash, with its short-term liabilities.

In cases like this, it is said that the company is illiquid. Many big companies have been forced to shot down for this reason.

Just as we had tools to measure the profitability of a companies, we also have tools that measure the liquidity of companies. Here are some of the ratios that help you determine the liquidity of a company by just looking at its financial statements:

Current Ratio

The current ratio is the most popular liquidity ratio formula and it is very easy to compute. It is determined by dividing total current assets by the total of current liabilities. As a rule of thumb, a proportion of 2:1 is perfect for this.

That is, your current assets are expected to be twice your current liabilities. If it is significantly higher than that, then the company is holding too much liquid assets, like cash, to ransom instead of putting it to good use.

Quick Ratio/ Acid Test Ratio

The quick ratio, also known as the acid-test ratio, follows closely from the current Ratio. It is, however, known to be a more accurate measure of short-term liquidity when compared to the current ratio.

The formula is essentially the same. The difference is only that with the quick ratio, you would calculate only assets that are the most easily convertible. For some people, this is only cash.

You can calculate it by adding cash, cash equivalents, short-term investments, and current receivables together then dividing them by current liabilities. Some people simply use current assets minus inventories and divide by current liabilities. Just like the current asset, a proportion of 1.5:1 is considered to be the best.

Cash Ratio

Cash ratio is simply the ratio of a company's cash and cash equivalent assets to its total liabilities. Think of it as one step even further from the quick ratio.

It shows how much cash is readily available to pay off current liabilities. The users of this ratio are primarily creditors who want to know how easily a company can service debt and cover short-term liabilities.

Net Working Capital Ratio

This ratio is not a proportion or percentage like the others. Rather, it is a figure to know exactly used to know the exact liquidity of the company per working capital. It is simply current assets minus current liabilities.

These ratios are easy to compute and can save you a lot of stress. After computing them, it is advisable to compare them with industry averages or the company’s trend.

Written by Lawretta Egba