The common denominator that all businesses have is the optimization of their available assets. This is where liquidity plays a fundamental role. To measure this optimization we use the liquidity ratio, which belongs to the group of liquidity financial indicators. In today’s post we will see what this liquidity index is, what information it provides, how it is calculated and finally, how we should interpret the information it gives us.

Liquidity indicators

 

Before looking at the liquidity ratio in detail, we must know that it is part of a group of liquidity indicators, used in the financial framework. This group is used to measure the financial strength or muscle of a company to meet its obligations.

The group is made up of the following indicators: working capital, acid test, cash ratiofinancial solidity and finally the liquidity ratio. Let’s see below what each of them means.

Working Capital

 

Working capital indicates in monetary terms the company ‘s available resources in the short term to develop its activities. The formula to calculate it is as follows:

Working Capital = Current Assets – Current Liabilities

Ideally, the result should be greater than zero since this indicates that the company has sufficient resources of its own. Otherwise, the company has all its resources with its immediate obligations.

Acid test

 

The acid test indicates the degree of availability of highly liquid resources without taking inventory into account. It is calculated as follows:

Acid Test = (Current Assets – Inventories) / Current Liabilities

Its interpretation is the same as that of the liquidity ratio, which we will see in detail later.

 

Cash ratio

 

The cash ratio indicates the relationship between the most immediate liquidity assets and current liabilities. That is, for each monetary unit of current liabilities, how many units of cash are available:

Cash ratio = Cash / Current Liabilities

 

This indicator analyzes the company’s capacity when it comes to assuming debts with a very short payment term and low amount.

Financial strength

 

Financial strength shows the total amount of assets the company has , for each unit of total liabilities. Its formula is as follows:

Financial Solidity = Total Assets / Total Liabilities

Finally, we would have the liquidity ratio, which we explain more in depth in the following sections.

 

What is the liquidity ratio

 

Like the acid test, the liquidity ratio indicates the ability of a company to meet its short-term debts. That is, how quickly a business can turn its available assets into cash. Here you have to pay special attention, you are not looking to sell the products as soon as possible but to measure the time it takes to transform the goods into money.

What is the liquidity ratio used for?

In most cases, the liquidity ratio is used to know what is called  financial health . In this way, all companies know their degree of solvency and their debt capacity, fundamental aspects in the strategic development of a business.

The borrowing capacity applies to both natural and legal persons. The indebtedness capacity of a natural person is the total amount of debt that can be assumed without endangering its economic well-being.

On the other hand, when we talk about business debt capacity, we refer to the maximum amount of debt that an entity can assume without putting its capital at risk.

In both situations, the objective is the same, not to borrow beyond our means and to have prior knowledge of the amount of debt that we can assume.

 

How the liquidity ratio is calculated

 

Like any ratio, there is a formula for its calculation and thus know our solvency capacity. The formula to calculate the solvency ratio is current assets divided by current liabilities, as follows:

 

Current liabilities/Current assets

We will have to analyze if this result is higher or lower than 1.

Current assets are also called current or liquid assets. It includes all the assets of the company that can be converted into liquid in less than a year (short term). On the contrary, in the current liabilities are all the debts of the company that expire in one year or less.

Interpretation of the result

Now that we have seen what the liquidity ratio is and how it is calculated, we must interpret the result.

The interpretation of the liquidity ratio will be one way or another depending on whether the result is greater or less than one. Let’s see what the difference is.

  • less than one

If we obtain a liquidity ratio less than one, this means that the company is having difficulty transforming its available assets into liquid. This can be a problem when dealing with short-term debts.

  • greater than one

If we obtain a liquidity ratio greater than one , it means that the company has good financial health. In other words, the company has no difficulties in transforming its available assets into liquid assets and meeting its short-term debts.

However, if the result is much higher than one, we must pay attention since it would be indicating that there are an excess of available resources that are not being exploited.

Finally, we see that there is no exact result when calculating the liquidity ratio. It will depend on the type of business, since some work better with excess liquidity and others, on the contrary, use financial instruments with very long-term payments . In the following link, you can analyze the different financial instruments that we offer and see which one best suits your needs.

Similarly, knowing and knowing how to interpret the liquidity ratio can help you efficiently manage and control your treasury. Aspect that will help you make decisions in your business and anticipate to avoid future payment problems.