More festival vibes with liquidity ratios
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.
Using her 15 years+ experience as a CA, Jordena helps Phocas develop financial products that save time and provide ways to extend analysis and performance.
How to improve cash flow in a manufacturing business
Manufacturers are responsible for ensuring an adequate supply chain for wholesalers, retailers, and, ultimately, the end user. When everything runs smoothly, a manufacturing business can be very profitable.
Read moreImprove planning with comprehensive sales forecasting
If the owner of your business wants to expand to a new State, would you have the sales forecasting figures to know whether the business can afford to do that or not? Or, if you had to produce a 3–year solvency projection for the CEO, is your sales forecasting process robust enough to support a reliable analysis?
Read moreWhat is financial modeling and common models to know
Predicting the future is a daunting task, unless you possess a time machine like Marty McFly in the 1985 film, 'Back to the Future'. If you don’t have such a tool, the next best thing is financial modeling. It can offer valuable insights and guidance into the future financial position of your business.
Read moreDifferent types of budgets for financial planning
As your business grows or becomes more complex it becomes crucial to have a budget plan. An essential tool in your Swiss army knife of financial planning is budgeting. A budget is a financial plan that outlines projected income and expenses over a specific period, typically a fiscal year. This not only provides a clearer view of your costs but also serves as a guide for managing and allocating financial resources to achieve organizational goals and objectives. Before we delve into the different types of budgets let’s explore the advantages of using a budget.
Read moreFind out how our platform gives you the visibility you need to get more done.
Get your demo today