Liquidity ratios - introduction
Liquidity ratios are concerned with the short term financial health of the business and whether the working capital of the business is being managed effectively. Working capital is the lifeblood of an organisation. Too little working capital and the firm may not be able to pay all of its debts, and ultimately this may result in closure. Too much working capital and the business may not be making the most efficient use of its financial resources for expansion.
Liquidity is the ability of a firm to meet its liabilities, to pay its bills. A firm is liquid if it can pay its bills, illiquid if it cannot. A firm may be illiquid for a time, but it may not matter. However, at another time a moment's lack of liquidity may be critical. It all depends (that phrase again!) which bill it is that the firm has to pay. The banks and the government pose the greatest problems, and particularly the government, as these payments are unavoidable. Thus there are some critical creditors who the firm must pay on time.
There is little liquidity information in the profit and loss account, but the balance sheet is more valuable. Liquidity is a short-term matter and can change very quickly, so it is always worth remembering that the balance sheet is simply a snapshot at a particular time.
Now, let's look at the balance sheet. The firm will have to meet its liabilities some time, but the current liabilities are the most important. As a reminder, current liabilities are:
These are people, firms and organisations to which the firm owes money. Some are more important than others. The critical creditors are probably the tax authorities (which collect company tax, employees income tax and sales tax) and the banks. Payments are due on a set day, and failure to pay may lead to the closure of the firm.
These are short-term borrowings from banks. Firms often use this as a means to make up for working capital shortages. They generally have to be cleared within 6 months.
If these are from banks they have to be paid. If the firm is reliable enough it may be able to re-organise an overdraft or short-term loan into a long-term loan.
On the other hand, the firm has its current assets to help it pay its bills. A reminder that current assets are:
Clearly very useful for paying bills as it is the most liquid of funds.
These are people or organisations, who owe the firm money. They should pay within the present financial year, depending on the credit terms given by the firm. They can be turned into cash quickly if it is necessary. The bills can be factored, that is sold to a firm, which will collect the revenue when they become due. Obviously, factoring companies will only pay a percentage of the value of the debts. Debtors are relatively liquid compared to other assets, but are not as good as cash.
These are assets of the firm and can, theoretically, be sold to raise cash. In reality, however, this may not always be the case. They may be out of season, unfashionable or even obsolete. They may not even be finished goods. Other firms or customers may not want them, and even if they do, only at a relatively low price. Stocks are considered to be the least liquid of the current assets.
There are two liquidity ratios:
- Current ratio
- Acid test ratio