Liquidity Ratios

Liquidity ratios are an important class of financial metrics used to determine a

debtor's ability to pay off current debt obligations without raising external capital.
Liquidity ratios measure a company's ability to pay debt obligations.
1) Current Ratio

The current ratio is a liquidity ratio that measures a company's ability to pay short-
term obligations or those due within one year. It tells investors and analysts how a
company can maximize the current assets on its balance sheet to satisfy its current
debt and other payables. The current ratio compares all of a company’s current
assets to its current liabilities. These are usually defined as assets that are cash or
will be turned into cash in a year or less, and liabilities that will be paid in a year or
less. The current ratio is sometimes referred to as the “working capital” ratio and
helps investors understand more about a company’s ability to cover its short-term
debt with its current assets.
Inferences:
A current ratio that is in line with the industry average or slightly higher is generally
considered acceptable. A current ratio that is lower than the industry average may
indicate a higher risk of distress or default. Similarly, if a company has a very high
current ratio compared to their peer group, it indicates that management may not be
using their assets efficiently.
A ratio under 1 indicates that the company’s debts due in a year or less are greater
than its assets (cash or other short-term assets expected to be converted to cash
within a year or less.)
On the other hand, in theory, the higher the current ratio, the more capable a
company is of paying its obligations because it has a larger proportion of short-term
asset value relative to the value of its short-term liabilities. However, while a high
ratio, say over 3, could indicate the company can cover its current liabilities three
times, it may indicate that it's not using its current assets efficiently, is not securing
financing very well, or is not managing its working capital.

2) Quick Ratio (Acid-Test Ratio)

CE= Cash and Equivalents, MS= Marketable Securities, AR= Accounts Receivables
The quick ratio is an indicator of a company’s short-term liquidity position and
measures a company’s ability to meet its short-term obligations with its most liquid
assets. Since it indicates the company’s ability to instantly use its near-cash assets
(assets that can be converted quickly to cash) to pay down its current liabilities, it is
also called the acid test ratio. An acid test is a quick test designed to produce instant
results—hence, the name.
Inference:
A result of 1 is considered to be the normal quick ratio. It indicates that the company
is fully equipped with exactly enough assets to be instantly liquidated to pay off its
current liabilities. A company that has a quick ratio of less than 1 may not be able to
fully pay off its current liabilities in the short term, while a company having a quick
ratio higher than 1 can instantly get rid of its current liabilities. For instance, a quick
ratio of 1.5 indicates that a company has $1.50 of liquid assets available to cover
each $1 of its current liabilities.

3) Cash Ratio

The cash ratio is a measurement of a company's liquidity, specifically the ratio of a

company's total cash and cash equivalents to its current liabilities. The metric
calculates a company's ability to repay its short-term debt with cash or near-cash
resources, such as easily marketable securities. The cash ratio is almost like an
indicator of a firm’s value under the worst-case scenario—say, where the company is
about to go out of business. It tells creditors and analysts the value of current assets
that could quickly be turned into cash, and what percentage of the company’s current
liabilities these cash and near-cash assets could cover.
Inference:
A cash ratio is expressed as a numeral, greater or less than 1. Upon calculating the
ratio, if the result is equal to 1, the company has exactly the same amount of current
liabilities as it does cash and cash equivalents pay off those debts.
If a company's cash ratio is less than 1, there are more current liabilities than cash
and cash equivalents. It means insufficient cash on hand exists to pay off short-term
debt. This may not be bad news if the company has conditions that skew its balance
sheets, such as lengthier-than-normal credit terms with its suppliers, efficiently-
managed inventory, and very little credit extended to its customers.
If a company's cash ratio is greater than 1, the company has more cash and cash
equivalents than current liabilities. In this situation, the company has the ability to
cover all short-term debt and still have cash remaining. While that sounds
responsible, a higher cash ratio does not necessarily reflect a company's strong
performance, especially if it is significantly greater than the industry norm. High cash
ratios may indicate that a company is inefficient in the utilization of cash or not
maximizing the potential benefit of low-cost loans: Instead of investing in profitable
projects, it's letting money stagnate in a bank account. It may also suggest that a
company is worried about future profitability and is accumulating a protective capital
cushion.

4) Defensive Interval Ratio

The defensive interval ratio (DIR), also called the defensive interval period (DIP) or
basic defense interval (BDI), is a financial metric that indicates the number of days
that a company can operate without needing to access noncurrent assets, long-term
assets whose full value cannot be obtained within the current accounting year, or
additional outside financial resources. Alternatively, this can be viewed as how long
a company can operate while relying only on liquid assets. The DIR is sometimes
viewed as a financial efficiency ratio but is most commonly considered a liquidity
ratio. Though a higher DIR number is preferred, there is no specific number that
indicates what is right or better to aim for.
5) Cash Conversion Cycle

The cash conversion cycle (CCC) is a metric that expresses the time (measured in
days) it takes for a company to convert its investments in inventory and other
resources into cash flows from sales. Also called the Net Operating Cycle or simply
Cash Cycle, CCC attempts to measure how long each net input dollar is tied up in
the production and sales process before it gets converted into cash received. This
metric takes into account how much time the company needs to sell its inventory,
how much time it takes to collect receivables, and how much time it has to pay its
bills without incurring penalties.
DIO and DSO are associated with the company’s cash inflows, while DPO is linked
to cash outflow. Hence, DPO is the only negative figure in the calculation. CCC will
differ by industry sector based on the nature of business operations. If two
companies have similar values for return on equity (ROE) and return on assets
(ROA), it may be worth investing in the company that has a lower CCC value. It
indicates that the company is able to generate similar returns more quickly.