Liquidity refers to how easily and quickly an asset can be converted into cash at its fair market value. So, cash is a liquid asset and real estate is an illiquid asset.
Just like individual assets can be liquid or illiquid, a company – as a whole – can also be liquid or illiquid.
An illiquid company is particularly vulnerable to downturns – more on this in a bit.
Through the use of liquidity ratios, it’s possible to assess your small business’s liquidity position and make sure you are prepared for a variety of scenarios.
Below, you’ll learn:
- Definition of liquidity ratios
- Why liquidity matters for small businesses
- Types of liquidity ratios
- Examples of liquidity ratio calculations
- The difference between liquidity and solvency
Let’s get started.
What are Liquidity Ratios?
Liquidity ratios measure a business’s ability to satisfy short-term financial obligations without raising funds from external sources.
Liquidity exists on a spectrum; for example, cash is extremely liquid and accounts receivable is still liquid, but less so. With this in mind, you want to assess your company’s liquidity by looking at a number of liquidity ratios, such as current ratio and cash ratio.
Why Does Liquidity Matter for Small Businesses?
As touched on earlier, an illiquid company might struggle in the event of an industry-wide (or broader) slowdown. If sales dip and it’s harder to secure short-term financing, having a lot of cash on hand can allow a company to continue paying the bills – without having to sell inventory, equipment, or real estate at a huge discount.
A strong liquidity position is essentially insurance for any unexpected financial difficulties.
Let’s say you are unable to sell your inventory as quickly as expected. If you have a lot of cash and accounts receivable (in dollars) relative to your current liabilities, you are less likely to have trouble covering your current liabilities.
Types of Liquidity Ratios
Here are four liquidity ratios to determine whether or not your company has enough liquidity.
The current ratio compares your current assets (e.g., cash and cash equivalents, accounts receivable, and inventory) to your current liabilities (e.g., accounts payable, short-term debt, and income taxes due in the next year).
Current Ratio = Current Assets / Current Liabilities
A current ratio of greater than one means your business has enough current assets to cover its current liabilities. A ratio of below one, on the other hand, means your current asset position is insufficient to cover your current liabilities.
But here’s the thing:
A current ratio below one isn’t always bad. For a fast-growing company with inventory flying off the shelves, a low current ratio might be beneficial. Check out the example of the e-commerce business that specializes in home aquariums in this article.
Also, you can look at closely related companies to determine whether or not you have a good current ratio.
What are your most successful, financially healthy competitors’ current ratios (assuming the information is publicly available)?
Quick Ratio / Acid Test Ratio
The quick ratio – aka the acid test ratio – is a stricter measure of liquidity than the current ratio – it only includes assets expected to be converted into cash within 90 days.
Here’s how it’s calculated:
Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
You may have noticed that inventory is excluded from the quick ratio. This is because inventory is often hard to liquidate in a short-period of time – without selling at a discount.
So, what is a good quick ratio?
It depends on your industry and the specifics of your small business.
For example, the average quick ratio in your industry is 1.15 and you collect payments faster than any of your competitors. In this case, a quick ratio of 1.15 would put you ahead of the competition – all other things being equal.
The cash ratio compares cash and cash equivalents to your current liabilities. So, it’s a very conservative measurement of a business’s liquidity.
Here’s how it’s calculated:
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
The cash ratio might seem too strict. For example, what if you have been consistently collecting payments from customers for several years?
But in the event of a financial crisis, you might be unable to collect accounts receivable and have to use your existing cash position to satisfy your short-term financial obligations.
In addition, the cash ratio is useful in normal times. Let’s say you have an outstanding current ratio and quick ratio, but you have very little cash and cash equivalents. In this case, you might not be able to withstand a few late payments.
So, you don’t necessarily need a cash ratio of above one. In fact, that might not be a good move – you would be tying up cash that could otherwise be invested in potential business opportunities.
At the same time, having some cash (the amount varies based on your industry and your risk tolerance) is important.
Defensive Interval Ratio (DIR)
The defensive interval ratio (DIR) measures how many days a company can continue operating while only relying on liquid assets.
Here’s the formula for defensive interval ratio:
Add up your cash, marketable securities, and net receivables. Take the result and divide by your daily operational expenses, which is (annual operating expenses – non cash charges) / 365. You now have your defensive interval ratio.
This liquidity ratio is a good way to determine how your company would fare if you experienced a significant reduction in cash flow – perhaps due to a recession.
DIR is also useful for businesses that experience fluctuating sales in normal times. A swimming pool company, for example, might not have enough operating cash flow to cover its daily operational expenses during the winter months. But if the company has a high defensive interval ratio, it would be less likely to run into financial problems.
As with other liquidity ratios, a good DIR depends on your industry and the specifics of your business.
Examples of Liquidity Ratio Calculations
Let’s calculate liquidity ratios for a hypothetical business: Clock Inc.
Here is a list of the relevant inputs:
- Cash: $20
- Cash Equivalents: $0
- Marketable Securities: $10
- Accounts Receivable: $40
- Net Receivables: $39
- Inventory: $20
- Current Liabilities: $70
- Daily Operational Expenses: $2
Now let’s calculate the ratios:
- Current Ratio = Current Assets / Current Liabilities
- (20+10+40+20)/70 = 1.29
- Quick Ratio = (Cash + Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
- (20+10+40)/70 = 1.00
- Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
- 20/70 = 0.29
- Defensive Interval Ratio = (Cash + Marketable Securities + Net Receivables) / Daily Operational Expenses
- (20+10+39)/2 = 34.5
Here are the industry averages:
- Current Ratio = 1.35
- Quick Ratio = 1.05
- Cash Ratio = .50
- Defensive Interval Ratio = 33
So, Clock Inc. appears to have worse liquidity than its peers, all things considered.
With that said, the current ratio and quick ratio are only slightly below average and the defensive interval ratio is slightly above average.
The cash ratio might be a cause for concern, however. In the event of a downturn, Clock Inc. might struggle to satisfy short-term financial obligations relative to its competitors.
Also, the defensive interval ratio of Clock Inc. and its competitors might be sufficient, but does predict issues if sales plummet for several months. This might be a risk worth taking – tying up funds means forgoing investment opportunities. Either way, it’s something to keep in mind.
Liquidity vs. Solvency: What’s the Difference?
While liquidity refers to a company’s ability to satisfy short-term financial obligations, solvency refers to a company’s ability to cover long-term financial obligations.
So, long-term debts would impact solvency but not liquidity.
In a short-term crisis, liquidity is typically a greater consideration than solvency. If, on the other hand, a company is facing the possibility of bankruptcy, you will hear a lot of talk about its solvency.
Further Reading: 7 Important Financial Ratios for Small Businesses.
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