What Are Liquidity Ratios?

Having a strong understanding of key financial metrics can help you become a well-rounded individual investor. Financial metrics in the areas of solvency, profitability, activity and liquidity all serve different purposes to assist investors in determining if a company is financially healthy before investing.

Although liquidity ratios are just one aspect of fundamental analysis, they play an important role in distinguishing between the companies that may be unable to pay back debts and the ones that can or use debt strategically within their business model.

Before you invest your hard-earned money in a company, vet it with liquidity ratios. Learn how to calculate liquidity ratios, what they are and how you can use them to evaluate a company’s viability and financial health.

What Does Liquidity Mean?

Before we jump into these ratios, let’s break down the term liquidity. Liquidity refers to the availability of liquid assets to a market or company. When evaluating the liquidity of a company, we look to see how easily and quickly it can convert its assets into cash. This is crucial for both a company and investor to measure and analyze overall liquidity.

Assets that can be sold and transitioned into cash in a short amount of time are deemed highly liquid. Having liquid assets allows a company to quickly raise cash in an emergency. For example, most stocks and other short-term investment instruments are highly liquid because they can be bought and sold quickly and turned into cash.

Lastly, companies aim to have good liquidity because it can help to attract investors as well as to overcome financial challenges by being able to easily secure loans and pay off existing debts.

What Are Liquidity Ratios?

Now that we have a clear understanding of what liquidity is, we can get into how investors use liquidity ratios to analyze a company before investing. Liquidity ratios are used to determine a company’s ability to meet its short-term debt obligations. Since a company that is consistently having trouble meeting its short-term obligations is at a higher risk of bankruptcy, liquidity ratios are a good measure of whether a company will be able to comfortably continue operating.

Liquidity ratios are especially important to creditors and vice versa because creditors allow companies to apply to take on new short-term debt like loans. By examining liquidity ratios, creditors can verify that a company is able to pay its short-term debt with ease or has a history of paying off its liabilities.

The level of liquidity needed varies from industry to industry because certain industries are more cash-intensive than others.

There are many differences between liquidity ratios and other financial metrics that measure financial health, such as profitability, solvency and activity ratios. While liquidity ratios determine a company’s ability to cover short-term obligations and cash flows, solvency ratios are concerned with a longer-term ability to pay ongoing debts.

Types of Liquidity Ratios

There are quite a few different types of liquidity ratios; the most common ones include:

• Current ratio: measures a company’s current assets against its current liabilities
• Quick ratio: also known as the acid-test ratio, which focuses on cash, short-term investments and accounts receivable

Other types of liquidity ratios investors may use to analyze a company before purchasing may include:

• Days sales outstanding (DSO): measures the average time it takes for a company to collect payment for a sale
• Inventory turnover ratio: measures if a business has excessive inventory compared to its sales level during a certain period

As we always stress in our articles, no matter what type of liquidity ratio you use to evaluate a company, you should always look at it in conjunction with other financial metrics to get the entire picture.

What Do Liquidity Ratios Measure?

Liquidity ratios are an important class of financial metrics that helps investors to measure a company’s ability to pay off current debt obligations without raising external capital. Investors care about a company’s liquidity because it indicates whether it has sufficient liquidity—through cash on hand or easily converted securities like stocks—to meet its financial obligations, while still covering payroll; paying vendors, other supplies and utilities; as well as maintaining the overall operations.

Comparing past liquidity ratios for a company to its current ratios allows analysts and investors to view changes in the company over time. This show investors if a company’s liquidity is improving—which could be a sign of a changed business model—or worsening, which could signal issues with sufficient cash flow.

Additionally, investors can use liquidity ratios to compare companies within similar industries. Liquidity ratios assist analysts and investors in assessing which companies may be in a stronger liquidity position. If the liquidity ratios indicate that a company has trouble meeting its short-term debt obligations for a number of years, you may want to avoid that company unless it can pledge its assets to raise cash until it has resolved its outstanding issues.

Generally, a higher liquidity ratio shows that a company is more liquid and has better coverage of outstanding debts. However, you will need to use your findings in conjunction with other financial metrics to solidify your judgment of a company’s financial health. While the primary purpose of the liquidity ratios is to determine the ability to meet short-term obligations, solvency ratios can help investors see the bigger picture when it comes to both short- and long-term debt.

 

Calculate Liquidity Ratios

Each type of liquidity ratios has its own formula . It’s important for investors to know how to calculate liquidity ratios on their own so they can cross reference companies in the same industry and see which are more liquid than the others. If you’re wondering how to calculate liquidity ratios, you can refer to the formulas below:

• Current ratio = Current assets ÷ Current liabilities
• Quick ratio = (Current assets – Inventory) ÷ Current liabilities
• Days sales outstanding (DSO) = (Accounts receivable ÷ Total credit sales) × Number of days in period analyzed
• Inventory turnover ratio = Cost of goods ÷ Average inventory

Any type of ratio analysis should be looked at within the correct context. For instance, investors should always compare a company’s ratios against those of its competitors, sector and industry over a period of several years.

How to Analyze Companies With Liquidity Ratios

Calculating financial metrics and ratios is typically the easy part. The challenge lies in analyzing liquidity ratios, interpreting their meaning and making an educated decision based on your findings. As with any ratio analysis, performing time series, competitive and industry/sector analyses are important before making any financial decisions.

As you use financial metrics like liquidity ratios to analyze a company’s financial health, you will want to be aware that an acceptable current ratio will be higher than an acceptable quick ratio. For example, a company may have a current ratio of 3.9 and a quick ratio of 1.9. Both of these numbers may be considered healthy by analysts and investors, depending on the company, its industry and its overall size.

Investors can analyze a company using liquidity ratios to ensure that a company is financially healthy and worthy of their investment. Working capital issues can often put severe restraints on a business, which could cause it to become net negative or even bankrupt. A company needs to be able to pay its short-term bills with some leeway as well as be able to handle these obligations over a number of years. Looking at the historical data of a company’s quick ratio and current ratio can help identify issues that may cause a business model to continue on a downward trend.

Liquidity Ratio Examples

We know that sometimes examples are the best way to show you how to calculate liquidity ratios. Let’s take a look at PepsiCo Inc.’s (PEP) quick and current ratios.

• Quick ratio: 0.67
  • Current assets minus inventory turnover: $17.44 billion
  • Current liabilities: $26.22 billion

Take the current assets and subtract the inventory turnover. Then, divide that number by the current liabilities to calculate the quick ratio for PepsiCo.

• Current ratio: 0.83
  • Current assets: $21.78 billion
  • Current liabilities: $26.22 billion

Similarly, take the current assets and divide that number by the current liabilities to calculate the current ratio for PepsiCo.

These examples use the liquidity ratios of PepsiCo as of December 2021.

Where Can You Find Liquidity Ratios?

You’ve chosen a few stocks in the same industry to compare, but you may be wondering how to find liquidity ratios on your own. On AAII.com, A+ Investors can find the current ratio in the “Ratios” section of our Stock Evaluator Pages. Use the search bar at the top of the page to type in any stock ticker to view this data. Additionally, A+ Investors can locate the “Financials” tab on the same page, where you will be able to look at a company’s annual and quarterly current liabilities, debts, etc., and calculate the ratios yourself.

Lastly, you can also find the numbers to calculate the current, quick as well as other types of liquidity ratios on the company’s balance sheet. You can find companies’ balance sheets with a simple Google search since they are deemed public records.

Using Liquidity Ratios to Invest

Knowing how a company handles its short-term debt obligations can help you more fully understand its capital structure, how it funds its assets and how it has performed these tasks in the past. It is important to understand how to calculate liquidity ratios such as the current ratio and quick ratio, as well as other metrics like DSO and the inventory turnover ratio.

Companies need to be liquid to pay their bills and not rely heavily on outstanding debt and loans. As always, it’s crucial not to analyze a single set of ratios, but to research the company using numerous metrics such as those in the areas of profitability, activity and solvency.

As an individual investor, you need to have the right tools and resources to purchase and sell securities with confidence. With A+ Investor, or our AAII Platinum bundle, you can have countless rankings, screens, commentary and grades to compare stocks or funds with ease.

Start analyzing your stocks’ liquidity ratios and overall performance today with A+ Investor.