Financial analysis indicators - liquidity
This series follows the series about Group of financial analysis indicators and describes in detail the indicators of liquidity.
Difference between terms liquidity, solvency and liquidity of assets
There is a difference between the related terms of liquidity, solvency and liquidity of assets.
Liquidity
Liquidity is the entity´s ability to convert its assets into cash for the purpose to settle its obligations, ideally with the lowest possible transaction costs. (14) More here.
Liquidity of assets
Liquidity of assets is the ability to convert assets into cash with the lowest transaction costs possible. (14) More here.
Solvency
Solvency is the ability to pay the obligations on time. (14) More here.
Liquid assets
Liquid assets are current assets that will or could be converted into cash in a short period of time. More here.
Liquidity indicators
Liquidity is the entity´s ability to convert its assets into cash for the purpose to settle its obligations, ideally with the lowest possible transaction costs. (14)
Indicators of liquidity
Liquidity indicators show the extent to which the current assets of the company in various forms cover its short-term obligations. Thus, the number of times the entity is able to settle its current liabilities from the conversion of the current assets to cash. Therefore, it evaluates short-term financial position of the company.
This category includes the following basic indicators:
- Current liquidity / Working capital ratio
- Acid-test ratio / Quick ratio
- Cash ratio / Absolute liquidity ratio
Their general interpretation:
- lower values indicate lower ability to pay short-term obligations
- too high values may indicate inefficiencies - it is recommended to evaluate them together with turnover ratios
- ideal values shall thus be neither low nor high
- recommended ideal values are stated within the description of each indicator individually
Comparison:
- with the recommended values
- however, some variations are possible by industry, type of company etc. - so it is very important to compare the indicators in time-series; it the company does not achieve the recommended values, but have done well without any problems, it can be then expected that it will continue to be successful with the same values in the future
- appropriate is the comparison is with the industry average or with similar companies in the industry
Possible reasons for higher liquidity (the reasons for the lower liquidity can be applied conversely):
- high levels of stocks (only for current liquidity)
- this can be related to the branch (e.g. commercial companies tend to have high stock values)
- high-quantity purchase of stocks due to favorable terms (discount), expected price increases or shortages
- seasonal fluctuation in demand
- stocks are overvalued - e.g. no legitimate provisions for inventories were made
- the company holds excessive inventory. The adequacy of the level of stocks can be assessed by using indicators of activity (Inventory turnover ratio or Inventory period).
- high receivable balances (only for current and quick liquidity ratios)
- high receivable recorded at the end of the year, which was not paid by the end of the year
- uncollectable debt increased
- higher maturity provided to customers, e.g. within acquisition or retention process
- receivables are overvalued, for example, e.g. no legitimate provisions to receivables were made
- low payable balances, e.g. due to effective supplier management
- economic growth, during which is the liquidity lower, because liabilities are growing faster than current assets (14)
Other indicators that may also be included among the indicators of liquidity:
Current liquidity ratio / Working capital ratio
Current liquidity ratio / Working capital ratio is one of liquidity indicators, which informs us how many times the firm would be able to pay its current liabilities, if it converts all of its current assets to cash.
Calculation formula
Disadvantages
- each component of current assets has different liquidity, which is not reflected by the current liquidity ratio formula
- formula does not take into account different maturities of receivables and liabilities
- does not make sense in the industries in which the companies must hold a large amount of stocks (e.g. trading businesses) - it is advisable to use indicators Quick or Cash ratio
Recommended values
ideal range is 1,5 - 2, but it depends on the industry a lot. It is especially higher for companies that must hold high inventory levels.
Interpretation
- lower values = lower ability to pay short-term obligations
- too high values = possible inefficiencies - it is recommended to evaluate them together with turnover ratios
- ideal values shall thus be neither low nor high
Comparison
- with the recommended values
- however, some variations are possible by industry, type of company etc. - so it is very important to compare the indicators in time-series; it the company does not achieve the recommended values, but have done well without any problems, it can be then expected that it will continue to be successful with the same values in the future
- appropriate is the comparison is with the industry average or with similar companies in the industry
Possible reasons for higher liquidity (the reasons for the lower liquidity can be applied conversely)
- high levels of stocks (adequacy to be evaluated together with indicator Inventory period days)
- this can be related to the branch (e.g. commercial companies tend to have high stock values)
- high-quantity purchase of stocks due to favorable terms (discount), expected price increases or shortages
- seasonal fluctuation in demand
- stocks are overvalued - e.g. no legitimate provisions for inventories were made
- the company holds excessive inventory. The adequacy of the level of stocks can be assessed by using indicators of activity (Inventory turnover ratio or Inventory period).
- high receivable balances (adequacy to be evaluated together with indicator Receivables collection period)
- high receivable recorded at the end of the year, which was not paid by the end of the year
- uncollectable debt increased
- higher maturity provided to customers, e.g. within acquisition or retention process
- receivables are overvalued, for example, e.g. no legitimate provisions to receivables were made
- low payable balances, e.g. due to effective supplier management. Adequacy of payables level an be evaluated by using indicator Days payable outstanding
- economic growth, during which is the liquidity lower, because liabilities are growing faster than current assets (14)
Quick ratio / Acid test ratio
Quick ratio (Acid test ratio) is one of liquidity indicators, which informs us about how many times the firm would be able to pay its current liabilities, if it converts its short-term receivables and financial assets to cash.
This indicator deducts the least liquid component from the current assets - inventories, or possibly also long-term receivables. It is therefore very useful in industries, where high level of stock must be held.
Calculation formula
Recommended value, interpretation and comparison
The recommended value is around 1. However, similarly with current liquidity ratio, it considerably depends on the industry.
Their general interpretation:
- lower values = lower ability to pay short-term obligations
- too high values = inefficiencies - it is recommended to evaluate them together with turnover ratios
- ideal values shall thus be neither low nor high
Comparison
- with the recommended values
- however, some variations are possible by industry, type of company etc. - so it is very important to compare the indicators in time-series; it the company does not achieve the recommended values, but have done well without any problems, it can be then expected that it will continue to be successful with the same values in the future
- appropriate is the comparison is with the industry average or with similar companies in the industry
Possible reasons for higher liquidity (the reasons for the lower liquidity can be applied conversely)
- high receivable balances (only for current and quick liquidity ratios)
- high receivable recorded at the end of the year, which was not paid by the end of the year
- uncollectable debt increased
- higher maturity provided to customers, e.g. within acquisition or retention process
- receivables are overvalued, for example, e.g. no legitimate provisions to receivables were made
- low payable balances, e.g. due to effective supplier management. Adequacy of payables level an be evaluated by using indicator Days payable outstanding
- economic growth, during which is the liquidity lower because liabilities are growing faster than current assets (14)
Cash ratio / Absolute liquidity ratio
Cash ratio (Absolute liquidity ratio) is one of liquidity indicators which informs us about how many times the firm would be able to pay its current liabilities, if it converts its financial assets to cash.
The indicator has only the most liquid component in the numerator - (short-term) financial assets comprising of cash, bank accounts and possibly short-term investments (short-term securities).
Calculation formula
Recommended value and interpretation
Recommended value: the ideal value is around 0,2 - 0,5.
Their general interpretation:
- lower values - lower ability to pay short-term obligations
- too high values = inefficiencies
- ideal values shall thus be neither low nor high
Comparison possible with
- recommended values
- in time-series; it the company does not achieve the recommended values, but have done well without any problems, it can be then expected that it will continue to be successful with the same values in the future
OTHER INDICATORS OF LIQUIDITY
Solvency
Solvency is the ability to pay the obligations on time. (14)
Solvency is not the same as liquidity.
Solvency ratio / Cash-flow ratio belongs to the group of indicators of liquidity and financial structure/indebtedness and expresses the entity's ability to meet all its liabilities (both short and long term).
The indicator is the reciprocal to the indicator Debt repayment period.
Calculation formula
Recommended value
the minimum value should be at least 0,2; ideally 0,2-0,3.
Working capital
Working capital is formed by current assets and includes inventories, receivables and financial assets.
It is another indicator of liquidity.
Calculation formula
inventories + receivables + financial assets
Another form of working capital is Net working capital.
Net working capital
Net working capital is obtained by subtracting short-term borrowings from (gross) working capital.
Calculation formula
working capital - short-term borrowings = current assets - short-term borrowings = long-term debt capital + equity – non-current assets
General interpretation of working capital and recommended values
the higher the value, the higher solvency and less risk; but too high values may indicate inefficiencies and lower profitability.
Net working capital is positive → over-capitalization, which means that:
- long-term funds are higher than fixed assets
- part of current assets are financed by long-term funds
→ lower risk (working capital serves as a buffer, because it is possible to use money raised from the potential sale of current assets financed by long-term sources for something else without compromising the stability of the entity)
→ lower efficiency because long-term funds tend to be more expensive than short-term
Net working capital is negative → under-capitalization, which means that:
- part of non-current assets were financed by short-term resources
→ i.e. the risk that the company will be forced to sell this part of the fixed assets to be able to pay its debts
Net working capital should in any case be positive. Nevertheless, the optimum amount of working capital, which outweighs the risk and profitability, shall be ascertained. There is no general recommendation; it always depends on circumstances (industry, the proportion of working capital components, inventory, receivables and payables turnover ratios etc.).