When evaluating a company’s financial situation, you can choose from multiple financial ratios and analyses, depending on your purpose. Leverage ratios focus on a company’s reliance on debt, solvency ratios on its ability to cover long-term debt obligations, and liquidity ratios on its ability to pay off short-term debt using liquid assets.
In this article, you will learn about liquidity ratios and why they are important. You will also learn how to set up a template for liquidity analysis in Google Sheets, using the formulas for the most popular liquidity ratios. Finally, you will learn how to interpret the values you get for these ratios. Although Google Sheets or Excel lets you automate calculations to save time and avoid mistakes, using Layer, you can synchronize your data across multiple platforms and formats, schedule updates, and manage access and collaboration.
What is a Liquidity Ratio?
Liquidity ratios are financial metrics that measure a company’s ability to meet its short-term obligations. In other words, these ratios indicate whether current liabilities can be paid using current or liquid assets. Depending on the specific ratio, the focus will be on current assets in general or highly liquid assets.
These ratios are of particular interest to short-term lenders and investors because they indicate the likelihood that the company will be able to pay off its short-term debt.
Why are Liquidity Ratios Important?
Liquidity ratios are important metrics when evaluating a company’s short-term financial health. Because they measure a business's ability to pay off current liabilities, short-term lenders and investors can use them to assess risk. These ratios indicate whether the company would be able to pay back short-term debt in the event of unexpected setbacks.
Current liabilities, generally used as the denominator for these ratios, usually refer to debt the company must pay back within a year. There are different types of liquidity ratios, and each considers a narrower subset of current assets. Together, they provide an overview of the company’s liquidity. These ratios are frequently analyzed together with solvency ratios, which focus on paying off long-term financial obligations, including any due interest.
The current ratio is a good measurement of a company’s liquidity. Here's everything you need to know about the current ratio and its calculation.READ MORE
Types of Liquidity Ratios
Depending on your role or the purpose of your analysis, you’ll be interested in different types of liquidity ratios. Although they all express a company’s ability to meet current liabilities, they differ in the selection of current assets considered.
The current ratio, for example, takes into account a broad range of current assets, including inventory and prepaid expenses; the quick ratio, however, only considers highly liquid assets, i.e., assets that can be converted into cash quickly. The cash ratio is even more restrictive since it only accounts for cash and cash equivalents. However, there are even more stringent liquidity ratios. The operating cash flow ratio only considers the cash flow generated directly by operations.
In the next section, you will learn the formulas to calculate these four liquidity ratios.
How are Liquidity Ratios Calculated?
Use the formulas below to calculate four of the most popular liquidity ratios.
- Current Ratio represents the company’s ability to cover current liabilities using current or liquid assets.
current ratio = current assets / current liabilities
- Quick Ratio represents the company’s ability to pay off current liabilities using highly liquid assets.
quick ratio = (cash + marketable securities + accounts receivable) / current liabilities
- Cash Ratio represents a company’s ability to pay for current liabilities using cash and cash equivalents.
cash ratio = (cash + marketable securities) / current liabilities
- Operating Cash Flow Ratio represents the company’s ability to pay off its current liabilities using the cash flow generated by core operations.
operating cash flow ratio = operating cash flow / current liabilities
In the next section, you have examples of calculating these in Google Sheets, using data from the company’s financial statements.
Liquidity Ratio Examples
The data you need to calculate liquidity ratios is on the company’s financial statements, like balance sheets or cash flow statements. You can easily set up a template in Google Sheets to calculate the ratios you need.
1. Gather Data
The first step is to gather the necessary data in your spreadsheet. The data below belong to Company A.
2. Add Formulas
Now that you have the data, you can add the formula for each ratio using cell references. Check the previous section, including the formulas.
Operating Cash Flow Ratio
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3. Analyze & Compare the Results
Once you have the values for your chosen liquidity ratios, you can interpret them using the general guidelines from the next section. However, remember that it’s important to compare your values to those of similar companies and use industry-specific benchmarks.
Liquidity Ratio Interpretation
As mentioned, financial ratios, including liquidity ratios, should be analyzed in context by comparing them to those of similar companies in the industry. Every industry has its specific customs and accounting practices, which could significantly impact the range of acceptable values for these ratios.
What is a Good Liquidity Ratio?
Because of how we calculate liquidity ratios - assets divided by liabilities, higher values are better. For the current ratio, a value of 1 indicates that the company can cover current debt using current assets. A ratio of 2 indicates it could pay for it twice, a more comfortable financial position.
However, some liquidity ratios take a much stricter approach and only consider cash and cash equivalents. A cash ratio below 1 shouldn’t necessarily be the cause for concern, particularly in specific industries.
You now know about liquidity ratios and what they can tell you about a company’s current finances. Together, these ratios provide an overview of how well a company can cover its current liabilities using current assets. You also know the formulas for the four most common liquidity ratios and how to interpret their values. As with any financial ratio, it’s important to get industry benchmarks and compare values to those of similar companies.
From the current ratio, which provides the broadest view of liquid assets, to the operating cash flow ratio, which is very specific, you can easily set up a quick template in Google Sheets. For a more comprehensive analysis, you can add other types of financial ratios to the template.
To learn more about financial ratios and analyses used to assess a company’s financial health and performance, check out these articles on: