Calculating a Company’s Liquidity Ratios
This calculator can be used to determine several liquidity ratios of a business based on information appearing on the balance sheet. The calculator needs a total of nine inputs, including:
- The value of the company’s cash and cash equivalents
- The value of the marketable securities held by the company
- The money owed the company from customers in the form of accounts receivable
- The money the company has invested in inventory
- The value of prepaid expenses found on the balance sheet
- Monies owed to vendors and suppliers as found in accounts payable
- Tax liabilities in the form of income taxes payable
- The value of all accrued liabilities
- Finally, any short-term debt appearing in the current liabilities section of the balance sheet
The calculator then provides the user with five outputs:
- The total of all the company’s current assets
- The company’s quick assets
- The total of all the company’s current liabilities
- Three liquidity ratios, including the current ratio, the quick ratio (also known as the acid test), and the cash ratio
What are Liquidity Ratios?
In finance, liquidity refers to the ability of a company to raise cash. Liquidity ratios are financial ratios that analysts calculate to determine a company’s ability to pay its lenders. Specifically, the ability to pay their current liabilities using some of their current assets. The three most common liquidity ratios are the same ones we calculate here: the current ratio, the quick ratio or acid test, and the cash ratio.
How are the Liquidity Ratios Calculated?
One thing all three of these ratios has in common is the value used in the denominator – current liabilities. The only factor that differs for each ratio is the value used in the numerator as shown below:
Current Ratio = Current Assets / Current Liabilities, where
- Current Assets = Cash and Cash Equivalents + Marketable Securities + Accounts Receivable + Inventory + Prepaid Expenses; and
- Current Liabilities = Accounts Payable + Income Taxes Payable + Accrued Liabilities + Short-Term Debt
Quick Ratio / Acid Test = Quick Assets / Current Liabilities, where
- Quick Assets = Cash and Cash Equivalents + Marketable Securities + Accounts Receivable + Prepaid Expenses
Cash Ratio = Cash Assets / Current Liabilities, where
- Cash Assets = Cash and Cash Equivalents + Marketable Securities
Looking at each of the above liquidity ratios, we can observe the current ratio is the most “forgiving” of the three since all current assets are measured against current liabilities. While inventory can be sold to generate cash, it will take some time to convert it into cash. This is why we also look at the quick ratio, which removes inventory from the numerator. The problem with the quick ratio is we also need to convert accounts receivable into cash to repay current liabilities. This means the ratio relies on the ability of the company to collect those monies, which also takes time. This leads us to the cash ratio, which contains only cash and cash equivalents and marketable securities in the numerator. These assets can be used to quickly repay current liabilities.
What are Considered “Good” Liquidity Ratios?
Given how each of these ratios are calculated, we know Current Ratio will be great than a company’s Quick Ratio and their Quick Ratio will be greater than their Cash Ratio. But what constitutes a good liquidity ratio? Since these ratios have assets in the numerator and liabilities in the denominator, we also know higher ratios are better than lower ones. In fact, the ideal situation would be for all three ratios to be greater than 1.0. That would tell us the company can repay all its liabilities just by using cash and marketable securities. Typically, an analyst would prefer to compare a company to its peers. Benchmarking the performance of a company against its peers removes the differences that can occur between industries. For example, one industry might require companies to maintain a large inventory, while another might have no inventory at all. While we think a cash ratio of 1.0 or higher might be good, comparing the ratio of one company to another in the same industry is a more appropriate analytical technique.