Any great festival takes place over several days and involves different types of entertainment, food, and cultural offerings.
As we continue our festival of metrics, our next area to explore is liquidity ratios. As with profitability ratios, liquidity ratios provide another valuable piece of insight into a company’s financial performance.
Why liquidity ratios matter
Liquidity ratios help assess if there are sufficient current assets available to cover current liabilities. A healthy liquidity ratio indicates your business can pay its expenses and debts through its profits.
If, on the other hand, your liquidity ratio is lower than expected, this may indicate a debt or cash flow problem—which you may decide to tackle by reviewing your financing, ramping up pressure on past-due accounts receivable, and negotiating longer pay cycles for your own accounts.
- Operating Cash Flow ratio: Is a measure of how many times an organization can cover its current liabilities from cash flows generated from operating activities. An alternative approach is to use your earnings before interest, taxes, depreciation, and amortization (EBITDA), an approximation for operating cashflow to measure how well the business covers liabilities.
- Current ratio: Measures your organization’s ability to pay short-term obligations, usually over the next 12 months. The current ratio is calculated by dividing current assets by current liabilities. One of the limitations of the current ratio is that it can include less liquid assets such as inventory which is why many organizations prefer to use the Quick ratio.
- Quick ratio (also known as the acid test ratio): Evaluates the amount of liquid (quick) assets available to cover liabilities, indicates short-term liquidity. Generally, the acid test ratio should be 1:1 or higher; however, this varies by industry. In general, the higher the ratio, the greater the company's liquidity (i.e., the better able to meet current obligations using liquid assets)
- Cash ratio: Calculates ability to repay short-term debt with cash resources and cash equivalents (such as savings accounts and money market instruments).
What liquidity ratios can do for your organization
When creditors extend credit to your organization, they typically analyze your liquidity ratio to determine the likelihood of repayment.
Since liquidity ratios can reveal whether the organization has sufficient funds to meet obligations, they can be an extremely useful tool for determining a company’s financial status. Customers’ procurement teams can use these liquidity ratios to determine whether your company can supply stock before placing an order. They can also weigh up whether your company is financially healthy enough to fulfill a contract.
Who can benefit from using liquidity ratios?
If you have a product/stock-driven business, liquidity ratios are powerful metrics to watch in combination with debtor days and stock turn.
As with any other financial ratio, observing the trends is important. If the liquidity ratios are frequently changing, that could indicate financial instability. If your liquidity ratios are trending downward over time, discussions need to take place cross functionally to fix the issues.
Best ways to use liquidity ratios
When you use liquidity ratios effectively, you can quickly diagnose cash flow issues or a trend in debt problems, which can be particularly relevant for stock-driven businesses. A liquidity ratio above 1.0 indicates that your company is financially healthy enough to cover its current bills.
Calculating liquidity ratios using a spreadsheet can be a time-consuming manual exercise. A modern finance solution, such as Phocas Financial Statements, enables your team to quickly pull the relevant data and automate the calculation of liquidity ratios within the software. Data analytics allow you to track this metric over time and drill down into the relevant data to determine where the problems lie.
Using Financial Statements, you can quickly create a standard profit and loss statement and add custom calculations, such as liquidity ratios.
To learn more about how Phocas’s financial solutions can deliver a festival-like experience for your finance team, download this ebook: Modern Financial Planning and Reporting.