Liquidity ratios – 3 in series of 6 on financial ratios

Your have probably heard the terms liquidity and solvency. Liquidity refers to the ability to convert assets to cash. For example, inventories may be more liquid (i.e. can be sold for cash quicker) than a non-current asset like a building. Solvency refers to the ability of a business to pay debts as they fall due. Liquidity and solvency are closely related concepts. If assets cannot be converted to cash, debts like loan repayments or payments to suppliers may not be met. To be unable to pay debts as they fall due means a business is insolvent, which can mean business failure. There are two useful ratios to help us assess the state of a businesses’ liquidity – the current ratio and the quick (or acid-test) ratio. The current ratio is:

Current ratio:                           Current assets

Current liabilities

The basic idea the current ratio is that for a company to be able to pay its debts as they fall due, current assets should cover current liabilities by a multiple. Generally a current ratio of at least 2:1 is good. This means that current assets are twice current liabilities. So, even if some stock could not be sold or some trade receivables not paid, current liabilities would still be covered for payment. However, the 2:1 figure is only a guideline. If we  calculate the current ratio for Diageo  plc for 2010 (from the statement of financial position on p. 108), we get:

6,952/3,944 = 1.76 : 1.

Although not 2:1, it should not be a major problem. Think about the type of business and the inventory it has – can you imagine Diageo having difficulty selling it’s stock of Guinness for example.

The Liquid ratio, and it is calculated as follows:

Liquid ratio:                            Current assets – inventory

Current liabilities

This ratio is also called the Quick ratio or the Acid Test ratio. It is very similar to the Current ratio, except that inventory is deducted from current assets. This is because inventory is typically regarded as being the least liquid current asset. Often the yardstick for the Liquidity ratio is 1:1, but this depends on the type of business. For example, large retailers may have relatively low stock and almost no receivables, which will skew the figure well below zero if we assume suppliers give credit.

If we  calculate the current ratio for Diageo  plc for 2010 (from the statement of financial position on p. 108), we get:

6,952-3,281/3,944 = 1.12 : 1

The Current and Liquid ratios serve as useful indicators of the liquidity/solvency or a business. However, as with other ratios, the trend over time is important. Any business may face short-term liquidity problems which could skew either of the above ratios. Short-term liquidity problems may arise if, for example, customers are slow to pay or inventories can’t be sold. Such problems are normally overcome through the  management of inventory and receivables, which I’ll deal with in the next post.

(Image above from withfriendship.com)