4 LIQUIDITY RATIOS

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It is essential that a firm can meet its obligations as they become due. 

This is exactly what liquidity ratios measure. They assess a company's ability to meet its current obligations.

Liquidity ratios are useful for creditors and commercial banks who provide short-term credit to businesses.

By financial convention, a short term credit is a debt that must be settled within one year.

Liquidity ratios are used to assess a company's short-term solvency. As a result, they're also known as short-term solvency ratios.

There are four major liquidity ratios, namely: current ratio, acid-test ratio, cash ratio and defensive interval ratio.

Current Ratio

It shows the number of current assets available in naira for every naira of current liabilities

It is calculated by dividing current assets divided by current liabilities

That is, the current ratio is

$$\text{current ratio}=\frac{\text{Current assets}}{\text{current liabilities}}$$

Current assets include cash and other assets that can be easily converted into cash. 

Examples of current assets are marketable securities, debtors, inventories, prepaid expenses and advance tax.

Current liabilities include all obligations that mature within a year.

Current liabilities include creditors, bills payable, accrued expenses, short-term bank loans, income-tax liability and other debt obligations maturing in one year.

Example

If the current assets of XYZ limited are N900,000 and its current liabilities is N400,000. Calculate its current ratio 

Solution:

$\text{ current ratio}=\frac{900,000}{200,000}=2.25$

Significance of the current ratio

The current ratio indicates how well a company's current liabilities are covered by its current assets.

When the current ratio is larger than one, the company has more current assets than current liabilities.

When the current ratio is equal to one, the company has the same current assets as its current liabilities.

When the current ratio is lesser than one, the company has more liabilities than the current asset

It should be mentioned that the current ratio represents a margin of safety for creditors.

The higher the current ratio, the greater the margin of safety. 

This is because the greater the current asset's value relative to current liabilities, the greater the company's ability to meet its short term obligations.


As a measure of liquidity, the current ratio has one drawback in that it includes stocks in its calculation.

Stocks are relatively difficult to convert to cash.

For instance, if a company needs to sell a large number of its stocks to meet creditors' demands, it may not be able to do so at a fair market price.

It is for this reason that the current ratio has been modified by excluding closing stock from the calculation.

The result is a quick ratio.

Quick Ratio

This ratio shows the relationship between quick or liquid assets and current liabilities

An asset is liquid if it can be converted into cash immediately or within a reasonable amount of time without a loss of value.

For this reason, cash is the most liquid asset as it is already in liquid form(cash)

Other assets which are considered to be relatively liquid and included in quick assets are book debts (debtors and bill receivables) and marketable securities (temporary quoted investments). 

Inventories are the least liquid current asset and are therefore excluded from current assets to get liquid assets.

The quick ratio is calculated as follows:

$$\text{quick ratio}=\frac{\text{current asses}- \text{inventories}}{\text{current liabilities}}$$

Significance Of The Quick Ratio

This ratio measures the company's ability to meet its debt without inventory.

A quick ratio lesser than one means that the liquid assets of a company are insufficient to cover all of its current liabilities.

A quick ratio equal to one means that the liquid assets of a company exactly equal its current liabilities

if the quick ratio is greater than one, it means that the company can settle its short term obligation and still have some funds leftover. 

Although there are divergent views on what constitutes an ideal quick ratio, a quick ratio of 1:1 Is considered ideal

Cash Ratio

Since cash is the most liquid asset, a financial analyst may examine the ratio of cash and its equivalent to current liabilities.

The cash ratio (sometimes known as the cash assets ratio) compares to cash and equivalents to current liabilities.

Cash and equivalents are included in this ratio, but trade receivables are not.

Trade receivables are excluded from the cash ratio because they are usually some doubts over their realization in time.

The cash ratio is the most conservative measure of liquidity ratios because it only considers cash and cash equivalents.

Trade investment or marketable securities are the equivalents of cash, therefore, they are included in the computation of cash ratio:

$$\text{Cash ratio}=\frac{\text{cash}+ \text{marketable securities}}{\text{current liabilities}}$$

It should be noted that the cash ratio is also called the absolute liquidity ratio.

Significance of cash ratio

The cash ratio indicates a company's ability to pay off its short-term obligations using cash and cash equivalents.

A cash ratio greater than one shows that a company can pay short-term liabilities with cash and equivalents while still having funds left over.

A cash ratio of one shows that a company's current liabilities are equal to its cash and cash equivalents.

A cash ratio lesser than one shows that a company's cash and marketable securities are insufficient to cover all of its short-term obligations.

Defensive Interval Ratio

This is a liquidity ratio that measures a company able to survive with its liquid assets alone.

It is the ratio of liquid assets to their daily operating cash flows.

The daily operating expenses is the cost of goods sold plus selling, administrative and general expenses all divided by 365.

$$\text{DIR}=\frac{\text{current assets}-\text{inventory}}{\text {Daily operating expenses}}$$

Significance Of Defensive Interval Ratio

A high defensive interval ratio is reasonable since it indicates that a corporation can use its liquid assets to fund its operating expenses.

Indeed, a high defensive interval ratio means a company can rely more on its liquid assets without seeking external finance, which is a sign of a strong company.

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Final words

All firms should ensure that it does not suffer from a lack of liquidity, and also that it does not have excess liquidity.

In a situation where there is inadequate liquidity,  the company will not be to meet its obligations to creditors, on the due date promised.

This can result in poor creditworthiness, loss of consumer confidence and even lead to the closure of the company.

Similarly, high liquidity is not desirable as it will result in idle assets, which, of course, earns nothing for the firm. 

Indeed, a very high degree of liquidity will be unnecessarily tied up the firm funds in idle current assets.

Excess and inadequate liquidity are not desirable. It is, therefore essential that a company strike the right balance between the two

Therefore, it is necessary that a firm strike the proper balance between high liquidity and lack of liquidity.

There you have it! For a recap, w discussed that liquidity ratios measure the short-term solvency of a business.

We also look at four types of liquidity ratios: current ratio, quick asset ratio, defensive interval ratio, cash ratio.

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