Learn how to calculate liquidity ratios and why the ratios are an important financial planning tool.

1 minute

July 11, 2024

Successful SMBs use financial tools to monitor business performance and make improvements. Short-term cash management is a high priority and liquidity ratios provide critical information for decision makers.

**This post defines many liquidity ratios and how the formulas are used in business. You’ll learn the best practices for liquidity ratios and how the analysis can improve business forecasting.**

Key highlights:

- A liquidity ratio measures a firm’s ability to to meet short-term financial obligations
- Solvency ratios determine a firm’s ability to meet all long-term obligations, including debt payments
- Founders utilize liquidity and solvency ratios to assess financial strength by considering specific account balances .

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Liquidity ratios measure a firm’s ability to generate sufficient current assets to pay all current liabilities. The accounting professional generally defines “current” as 12 months or less.

The period to measure liquidity is 12 months or less, and solvency involves periods of a year or more.

Solvency ratios determine a firm’s ability to meet all long-term obligations, including debt payments. To be solvent, a business must generate sufficient long-term assets to pay all long-term liabilities.

Short-term and long-term periods may be defined differently, depending on the business and industry. An established company with consistent earnings may plan for 10 years or more. A startup business with more uncertainty may only plan for the next 18 months.

Defining a good liquidity ratio depends on industry averages and how long the business has operated. Keep in mind that real estate, fixed assets, and other long-term assets are difficult to liquidate.

Standard Brands is a CPG company. Here is the company’s balance sheet as of 12/31/24, and an income statement for the year ended 12/31/24:

These financial statements are used in this discussion to calculate financial ratios. Business owners may use Excel or financial software to calculate financial ratios.

To understand liquidity ratios, start with a review of working capital.

Working capital is (current assets less current liabilities) and measures a firm’s ability to generate sufficient cash inflows to pay all current liabilities.

**Current assets:**A company’s current assets include cash and assets that will be converted into cash within 12 months. Accounts receivable and inventory are current asset accounts.

**Current liabilities**: The balance includes accounts payable and other short-term liabilities that must be paid in cash within 12 months. The current portion of long-term debt (payments due within a year) is a current liability.

- Businesses strive for a positive working capital balance, meaning current assets are greater than current liabilities. These firms have enough cash to pay the company’s short-term liabilities.

The most common liquidity ratios are explained below.

The current ratio (working capital ratio) is (current assets divided by current liabilities). Here is the calculation using the financial statements:

($610,000 current assets) / ($125,000 current liabilities) = 4.88

The business needs a current ratio of 1 or greater so that current assets are at least equal to current liabilities. In this example, current assets are more than four times current liabilities. A high ratio indicates more liquidity.

The quick ratio (acid test ratio) adjusts the current ratio. The formula is (current assets less inventory) divided by current liabilities. The calculation is:

($610,000 current assets - $250,000 inventory) / ($125,000 current liabilities) = 2.88

Inventory may be slower to convert into cash than other current assets. Accounts receivable balances, for example, are typically collected in 60 to 90 days. Inventory, however, may take months to sell. The quick ratio is a more conservative view of a firm’s liquidity position.

The cash ratio only considers the current assets that are the most liquid assets. As an example, marketable securities can be sold quickly and are easily converted into cash in a day or two. The ratio formula is (cash plus marketable securities) divided by current liabilities. The example calculation:

($80,000 cash + $30,000 marketable securities) / ($125,000 current liabilities) = 0.88

This formula is a more conservative view of a company’s liquidity than the current ratio or the quick ratio because the cash ratio measures the most liquid assets.

The cash ratio is the best tool to measure liquidity, if you had to pay all current liabilities in three days.

Higher liquidity ratios are preferred for the three ratios discussed above. A low liquidity ratio means the company may find it difficult to meet all of its current debts and obligations.

Days sales outstanding (DSO) ratio is the average number of days required to convert all credit sales into cash. The formula is 365 days X (average accounts receivable divided by net credit sales).

To compute DSO, assume that the average accounts receivable balance is $220,000, and that net credit sales total $800,000. The DSO calculation is:

365 days X ($220,000 average accounts receivable / $800,000 net credit sales) = 100.375 days

If a company’s DSO ratio is increasing it means that cash collections are slowing and the business may experience a cash shortage.

Days Payable Outstanding (DPO) ratio calculates the average number of days required for a company to pay back its accounts payable. The formula is 365 days X (average accounts payable divided by the cost of goods sold).

To compute DPO, assume that the average accounts payable balance is $100,000. The cost of goods sold balance in the income statement above is $431,667. The calculation is:

365 days X ($100,000 average accounts payable / $431,667 cost of goods sold) = 84.56 days

Both DSO and DPO are calculated based on days. DSO addresses collections and DPO analyzes payments.

The operating cash flow ratio using the direct method uses cash receipts and cash payments for operating transactions. Operations refers to the day-to-day activities required to manage the business. The formula is:

(Cash received from customers – cash paid to suppliers and employees - cash paid for other expenses)

OCF cannot be calculated using balance sheet account balances or cash flow from operating activities in the statement of cash flows. Instead, the data to compute OCF is pulled from the detail of cash deposits and payments.

Notice also that OCF does not consider cash outflows for short-term debt obligations (such as a line of credit) or cash inflows from short-term investments (money market accounts, certificates of deposit, etc.)

The times interest earned (TIE) ratio assesses how well a business generates earnings to pay interest on debt. TIE is classified as a solvency ratio because most debts are long-term liabilities.

The current portion of long-term debt is a current liability, so TIE can also be analyzed with liquidity ratios. The formula is EBIT (earnings before interest and taxes) divided by total interest expense on outstanding debt. Here is the calculation using the example data:

($472,500 EBIT) / ($24,500 interest expense) = 19.29

If interest or principal payments are not paid on time, the borrower defaults on the debt, and a default impacts your ability to borrow in the future. While a company’s TIE ratio does not account for cash, managers must collect sufficient cash to make interest payments.

Business owners can assess liquidity ratios by considering the specific account balances used in each formula.

Liquidity ratios answer this question: What assets can I convert into cash within 12 months, and what liabilities must be paid in cash within a year? Liquidity ratios differ, based on assumptions about cash inflows and outflows.

The current ratio takes a broad view of liquidity by considering all current assets and liabilities. The quick ratio is more conservative and removes inventory from the current asset total.

A car manufacturer, for example, may have vehicles sit in inventory for months before they are purchased. In this case, the quick ratio is a better liquidity metric than the current ratio.

The cash ratio only considers the current assets that are the most liquid and is a more conservative metric than the current or quick ratio.

DPO and DSO take a different approach by measuring cash receipts and payments by the number of days. Finally, operating cash flow analyzes cash receipts and payments related to day-to-day operations, not from investing or financing activities.

Businesses can’t reach long-term growth objectives without first ensuring company liquidity. Payroll is a good example. Owners need to generate enough current assets to fund payroll. If not, the firm can’t maintain a talented staff, and long-term goals can’t be reached.

Liquidity ratios help an owner determine if the business has short-term viability. For example, if cash collections are too slow, management can make changes to improve liquidity.

Short-term obligations must be paid to continue business operations and liquidity ratios measure the ability to pay current obligations.

In addition to payroll costs (mentioned above), supplier invoices must be paid on time. Businesses need reliable suppliers who provide quality products at a reasonable price, and vendors should be paid promptly.

Bank and credit card providers use liquidity ratios to evaluate a company’s ability to repay obligations.

Lenders assess the firm’s use of credit in the past, and if balances were paid on time. A lender may also review the applicant’s financial statements and use liquidity ratios to assess creditworthiness.

Operational efficiency is the number of days a business can operate without selling long-term assets to fund operations. Ideally, monthly sales and cash collections pay for all current liabilities.

Fixed assets should be used for long-term purposes, not sold to fund short-term cash needs.

Consistently strong cash inflows are an important metric for a business valuation. Reliable cash inflows demonstrate financial stability and make it easier to raise capital by issuing debt.

To illustrate, many investors use the multiple on invested capital (MOIC) ratio to evaluate an investment’s performance. MOIC is calculated as total cash inflows divided by initial capital invested. A founder who consistently generates more current assets than current liabilities can produce a higher MOIC ratio.

Liquidity ratios measure short-term financial results but don’t provide a complete picture of financial performance.

**Simplicity**: VC investors, creditors, and other stakeholders prefer liquidity ratios because the ratios are easy to compute. The ratios provide useful information and are simple.**Comparisons**: Analysts use liquidity ratios to compare financial results across businesses and industries. Grocery stores customers, for example, pay in cash or by credit card, and cash inflows are strong. Store owners should compare liquidity ratios with industry peers.**Minimize borrowing**: When owners manage liquidity ratios and make changes to increase cash inflows, the business can avoid borrowing funds and minimize interest costs.

**Static view**: Liquidity ratios provide a static view for a point in time (using the balance sheet) or for a specific period (income statement data). Many businesses experience huge changes in cash flows due to the seasonality of customer demand. The fluctuations may not be identified using a liquidity ratio.**Short-term focus**: Liquidity ratios do not provide data on long-term assets and liabilities, or long-term cash flow management.**Interest rate changes**: If interest rates decline sharply, short-term borrowing is less expensive and may be a better option for cash flow management. This factor is not considered when liquidity ratios are used.

Managers use additional ratios to assess performance and to make business decisions.

Founders, investors, and creditors need to assess company profitability. Here are two frequently used profitability ratios:

**Return on equity (ROE)**: ROE measures how well a company uses equity to generate a profit. The formula is (net income - preferred stock dividends) divided by (average equity balance).**Return on assets (ROA)**: ROA calculates profitability compared to assets used to produce revenue. The formula is net income divided by total assets.

Well-managed businesses maximize the profit generated from the equity and assets on the balance sheet.

These ratios assess solvency (long-term company viability) and financial risks:

The debt service coverage ratio determines if a company can pay all interest and principal payments (also called debt service). The formula is (net operating income divided by debt service). A business that cannot finance all debt payments is at risk of default.

Firms use the net debt to EBITDA ratio to determine if the business can repay all financial obligations. Note the following:

**Net debt**is defined as short-term debt plus long-term debt less cash and cash equivalents.**Cash and cash equivalents**include cash and assets that are easily converted into cash, such as commercial paper and marketable securities.**EBITDA**refers to earnings before interest, taxes, depreciation, and amortization.

A company’s financial health depends on the total debt, and the current income (earnings) the firm can generate. For example, a ratio of 3 means that net debt is three times EBITDA. Reducing net debt and increasing EBITDA improves a company’s financial health.

Control ratios measure the efficiency of business operations. Managers first compare budgeted performance to actual results. A variance is a difference between budgeted and actual data and variances can be expressed as a ratio. The capacity ratio is one example.

Assume that a company budgets 2,500 monthly hours for a particular machine and actual use is only 2,470 hours. The variance is due to the repair and maintenance required for the machine. The capacity ratio calculates the percentage of capacity used during the period. The formula is:

(2,470 actual hours divided by 2,500 budgeted hours) X 100 = 98.8

These two turnover ratios are used to monitor cash collections and to assess how quickly cash is paid for purchases.

**Accounts receivable turnover ratio**: This ratio measures how quickly a business collects cash from credit sales. The accounts receivable turnover ratio is (net credit sales) / (average accounts receivable). This article explains why the ratio is important.

**Accounts payable turnover ratio**: This ratio measures how quickly a business pays its total supplier purchases. The accounts payable turnover ratio is (net credit purchases) / (average accounts payable). You can read more about the ratio in this article.

Liquidity ratios measure a firm’s ability to convert current assets into cash to pay all current liabilities. Profitability ratios determine how much profit is generated when compared to equity, assets, and other balances.

Liquidity ratios measure a firm’s ability to generate sufficient current assets to pay all current liabilities. Accounting professionals generally define “current” as 12 months or less.

Business owners must monitor liquidity to meet all short-term obligations.

Liquidity ratios use many accounts in the balance sheet. Most of the calculations use current assets and current liabilities.

The period to measure liquidity is 12 months or less, and solvency involves periods of a year or more. Solvency ratios determine a firm’s ability to meet all long-term obligations, including debt payments.

The assessment depends on the specific ratio. A high current ratio means that current assets are much greater than current liabilities, which is preferred.

A high days sales outstanding ratio indicates that the average number of days required to convert all credit sales into cash is high. When more days are needed to convert sales into cash, the business may not pay all short-term obligations.

The most commonly used liquidity ratios are the current ratio and the quick (acid test) ratio.

Each ratio provides a slightly different view of liquidity. To effectively manage liquidity, owners need multiple sources of data.

Each liquidity ratio helps you make informed cash management and financing decisions. Calculating these ratios necessitates clean data and founders can leverage technology to save time.

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