Liquidity Ratio: Types and Formula

What is the Liquidity ratios?

In the previous chapter, we started ratio analysis with the first classification of financial ratios, i.e. turnover ratio. In this chapter, we will examine the second classification, i.e. liquidity ratios. 

As discussed earlier, liquidity ratios are employed by analysts to determine the firm’s ability to pay its short-term liabilities. The ratios calculated under this category aim to measure the short-term paying capacity of the company to avoid a liquidity crisis-like situation. 

1. Current Ratio 

It is one of the most common measures of liquidity. It measures the current assets available to pay off the current liabilities. Here, both the numerator and denominator contain items that are of a short-term nature. 

Formula of currency ratio:

Current Ratio = Current assets / Current liabilities 

A ratio greater than 1 suggests that current assets are higher than current liabilities and are sufficient to settle their current liabilities as and when they arise. Although the current ratio of 2 is usually preferred in the investor community, one should always consider the industry norms and identify the possible range of values before concluding. 

Interpretation of the ratio: 

• The higher the current ratio, the higher the chances for the company to be able to pay its short-term dues. 
• A current ratio of less than one indicates that the company's current liabilities are higher than existing assets. Therefore, the company has negative working capital and is likely facing a liquidity crisis. As discussed earlier, working capital equals current assets minus current liabilities.

2. Quick Ratio 

The quick ratio is also called the acid test ratio. It is a stricter measure of liquidity than the current ratio because it excludes inventories and other assets that might not be very liquid. Inventories are excluded as they might take time to convert into cash receipts and thus may not be immediately available to settle the current liability if it arises. 

Formula of Quick Ratio:

Quick ratio = (Current assets - inventories) / Current liabilities 

Interpretation of the ratio: 

• The higher the quick ratio, the more likely the company will be able to pay its short-term dues. 

A ratio greater than 1 suggests that liquid assets are higher than current liabilities and are sufficient to settle their current liabilities if they arise immediately. Although the quick ratio of 1 is usually preferred in the investor community, one should always look at the industry norms and identify the possible range of values before concluding. 

3. Cash Conversion Cycle

The cash conversion cycle is the time it takes to turn the firm’s cash investment in inventory back into cash in the form of collections from the sales of that inventory. It has three components.

Formula of Cash Conversion Cycle:

Cash Conversion Cycle = Days sales outstanding + Days of inventory on hand – Number of days of payables

In the first chapter of ratio analysis, we have seen the calculation of the above components used in measuring the cash conversion cycle. The ideal situation for the company is to keep its cash conversion cycle as short as possible. It can be achieved by selling the inventory and quickly receiving payment from debtors while delaying payments to creditors. 

Interpretation of the Cash Conversion Cycle:

• Usually, high cash conversion cycles are considered undesirable. 
• A conversion cycle that is too high implies that the company has an excessive amount of capital investment in the sales process.
• A lower cash conversion cycle also lowers the requirement for firms to maintain a high amount of working capital. Therefore, the firm's liquidity position stands strong. 

Numerical example with solution

In the above section of this chapter, we discussed various liquidity ratios. Applying and analysing the ratios on a company's actual financial statements is equally important. For this chapter, and going further, we will be calculating and analysing the financial statements of XYZ Ltd. The financial statements of XYZ Ltd were discussed in detail in the financial statement chapters. The steps you need to follow to understand this section are simple:

Step 1 - Snapshots of the actual financial statements are provided below. These statements consist of the crucial financial statements of XYZ Ltd - Statement of profit and loss, balance sheet and cash flow statement. 

Step 2 - A table named ‘Data Extract’ is provided below the snapshot for easy understanding. This table will include all the important line items and related numerical data from the financial statements of XYZ Ltd. needed to calculate a particular category of the ratio, like in this chapter - liquidity ratios. Please note all the amounts are in ₹ crores.

Step 3 - The solutions table is provided below the data extract table. This table includes the value of all the ratios taught in a particular chapter. However, you are expected to calculate the ratio value by yourself and then match your answers with the solution table to understand the concept better.

Step 4 - The analysis and interpretation section is provided towards the end. This includes the analysis of XYZ Ltd based on ratios calculated. 

Let’s start with the exercise:

Financial statements of XYZ Ltd 

Data extract:

Extract of data needed for liquidity ratios
	[Amount in ₹ crores. ]	[Amount in ₹ crores. ]
Particulars	March 2023	March 2022
Total current Assets	4,248	4,316
Total Current Liabilities	3,609	3,322
Current assets - Inventory	2,224	2,405
Days sales outstanding	23.64
Days of inventory on hand	114.58
Days payables outstanding	729.13

Solution:

Value of liquidity ratios
Current ratio	1.177
Quick ratio	0.616
Cash conversion cycle	-590.89

Analysis and interpretation 

• From the above solutions table, you can see that the current ratio of XYZ Ltd. is greater than 1. This means that the company has positive working capital, i.e. current assets are more than current liabilities. 
• However, when we look at the quick ratio, it shows a different picture, which raises concerns over the immediate short-term liquidity position. This is because the ratio is less than 1, which tells you that inventory forms a major part of the current assets and is not immediately realisable in cash. However, should it be a cause of worry? Looks like not in the case of XYZ Ltd as the company is enjoying negative working capital cycles. Thus, this shows that the company's liquidity position is strong as it can collect timely payments from its debtors and quickly sell its inventory. 
• However, when it comes to payment to creditors, the company is using strong credit terms to pay back its creditors. Thus, it can delay its payment to creditors. 
• Overall, the liquidity position of XYZ Ltd seems to be strong. Of course, this should not be looked upon in isolation. Comparison with its historical value of ratios and peer comparison is equally important to conclude the findings. 

Where Can I Check Fundamental Ratios on Angel One?

In order to check fundamental ratios on Angel One, simply:
1. Click on the stock from the search bar or from the Watchlist.
2.Click on ‘Overview’ and thereafter, click on ‘Stock Details’.
3. Scroll down and you will find fundamental ratios.

Summary of Liquidity Ratios

So, this was all about liquidity ratios. If you want to measure the firm's short-term paying capacity, then liquidity ratios are for you. There are various other liquidity measures, too, and the list is endless, but we have tried to cover the most prominent ones. 

Now, on to the subsequent classification of ratios, i.e. solvency ratios.