Analysis of Liquidity Position Using Financial Ratios

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In business analysis, liquidity measures how much cash a company can quickly generate. This provides insight into how well the business might fare in unexpected circumstances. A company with a lot of liquidity will be able to quickly come up with the cash they need to keep operations running through turbulent times.

Here are a few methods for measuring a company's liquidity.

Key Takeaways

• Three important liquidity measurements are the current ratio, the quick ratio, and the net working capital.
• The current ratio is calculated by dividing current assets by current liabilities.
• The quick ratio is similar to the current ratio, but it subtracts inventory from current assets before dividing it by current liabilities.
• You can calculate net working capital by subtracting current liabilities from current assets.

Calculate the Company's Current Ratio

The first step in liquidity analysis is to calculate the company's current ratio. The current ratio shows how many times over the firm can pay its current debt obligations based on its assets. "Current" usually means fewer than 12 months. The formula is:

Current Ratio = Current Assets/Current Liabilities

In the balance sheet, you can see the highlighted numbers. Those are the ones you use for the calculation. For 2021, the calculation would be:

Current Ratio = \$708/\$540 = 1.311 X

This means that the firm can meet its current short-term debt obligations 1.311 times over. To stay solvent, the firm must have a current ratio of at least one, which means it can exactly meet its current debt obligations. In other words, this firm is solvent.

However, in this case, the firm is a little more liquid than that. It can meet its current debt obligations and have a little left over. If you calculate the current ratio for 2020, you will see that the current ratio was 1.182.

Note

The firm improved its liquidity in 2021 which, in this case, is good since it is operating with relatively low liquidity.

Calculate the Company's Quick Ratio or Acid Test

The second step in liquidity analysis is to calculate the company's quick ratio or acid test. The quick ratio is a more stringent test of liquidity than the current ratio. It looks at how well the company can quickly meet its short-term debt obligations without taking the time to sell any of its inventory to do so.

Inventory is the least liquid of all the current assets because you have to find a buyer for your inventory. Finding a buyer, especially in a slow economy, is not always possible. Therefore, firms want to be able to meet their short-term debt obligations without having to rely on selling inventory. The formula is:

Quick Ratio = Current Assets-Inventory/Current Liabilities.

In the balance sheet, you can see the highlighted numbers. Those are the ones you use for the calculation. For 2021, the calculation would be:

Quick Ratio = \$708-\$422/\$540 = 0.529 X.

This means that the firm cannot meet its current short-term debt obligations without selling inventory because the quick ratio is 0.529, which is less than one.

Note

To stay solvent and pay its short-term debt without selling inventory, the quick ratio must be at least one. The company in this example does not satisfy that requirement.

However, in this case, the firm will have to sell inventory to pay its short-term debt. If you calculate the quick ratio for 2020, you will see that it was 0.458. The firm improved its liquidity by 2021 which, in this case, is good, as it is operating with relatively low liquidity. It needs to improve its quick ratio to above one so it won't have to sell inventory to meet its short-term debt obligations.

Calculate the Company's Net Working Capital

A company's net working capital is the difference between its current assets and current liabilities:

Net Working Capital = Current Assets - Current Liabilities

For 2021, this company's net working capital would be:

\$708 - 540 = \$168

From this calculation, you know you have positive net working capital with which to pay short-term debt obligations before you even calculate the current ratio. You should be able to see the relationship between the company's net working capital and its current ratio.

For 2020, the company's net working capital was \$99, so its net working capital position, and, thus, its liquidity position, has improved from 2020 to 2021.

Summary of Liquidity Analysis

In this example, you performed a simple analysis of a firm's current ratio, quick ratio, and net working capital. These are the key components of a basic liquidity analysis for a business. More complex liquidity and cash analysis can be done for companies, but this simple liquidity analysis will get you started.

Looking at this summary, the company improved its liquidity position from 2020 to 2021, as indicated by all three metrics. The current ratio and the net working capital positions both improved. The quick ratio shows that the company has to sell inventory to meet its current debt obligations, but the quick ratio is also improving.

For a true analysis of this firm, it also is important to examine data for this firm's industry. Although it's helpful to have two years of data for the firm, which provides information on the trend in the ratios, it is also important to compare the firm's ratios with the industry.

The Bottom Line

These three measurements are important first steps in gauging your company's liquidity. Start with these calculations to get a general sense of how your business's finances are doing. Then, compare your results to others in the industry, as well as other periods in your business's history. Financial data only becomes useful when it is compared to similar companies or historical data.

Why is liquidity analysis important?

Liquidity analysis allows you to gauge a company's ability to adapt. When unforeseen expenses arise, a company with high liquidity will be able to easily cover the costs, while a company with low liquidity may be forced to sell off assets or take on debt. This information is useful for analysts inside the company, as well as for investors considering whether or not to invest in a given company.

What are the 3 liquidity ratios?

The three main liquidity ratios are the current, quick, and cash ratios. The current ratio is current assets divided by current liabilities. The quick ratio is current assets minus inventory divided by current liabilities. The cash ratio is cash plus marketable securities divided by current liabilities.