In our last blog post, we covered the three financial statements every business owner needs to know. These are the balance sheet, income statement and statement of cash flow. Now that you have a good understanding of the main financial statements and their components, it’s time to learn how to use this information to evaluate the financial and operating performance of your business over time. This concept is known as financial ratio analysis – or more simply, ratio analysis.
Ratio analysis is performed by comparing two items in a single financial statement or between two financial statements. For example, comparing assets to liabilities on the balance sheet or comparing net income (on the income statement) to shareholders equity (on the balance sheet). The result offers an insight into the financial health of your organization that could not be gathered if the two items were analyzed on their own.
There are several different aspects of business performance that you may want to measure using ratio analysis. These include: profitability, liquidity, management efficiency, leverage, and valuation and growth. In today’s post we will be focusing specifically on liquidity ratios.
We will explore:-
- The definition and importance of liquidity
- Key liquidity ratios — definition, calculation and interpretation
- Working capital
- Current ratio
- Quick ratio
- Cash Asset ratio
- Ways to improve liquidity
Let’s take each of these in turn.
Understanding Liquidity Ratios: The 3 Main Components
#1. Definition and Importance of Liquidity
According to Investopedia, liquidity “describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price.” In other words, an asset is liquid if it is easily convertible to cash. Examples of liquid assets include stocks, bonds and money market mutual funds.
Without a good degree of liquidity, your business runs the risk of not being able to pay the bills, or worse case, keep its doors open.
However, on their own, understanding which assets are liquid and which aren’t, does not tell you much. That’s where ratios come in.
#2. Key Liquidity Ratios
Let’s review the key liquidity ratios below.
Working capital is the most basic measure of liquidity.
Calculation: Current Assets minus Current Liabilities
Interpretation: It is important to note that even if a business has a significant level of working capital, it could still experience periods where cash is strained if the current assets are not very liquid (as in the case of slow-moving inventory). It is therefore important to keep a close eye on how quickly your current assets are converting into cash and make adjustments as needed. You never want to be in a position where you cannot meet your immediate needs, such as, fulfilling payroll.
Like working capital, the current ratio also measures a company’s ability to meet its short term obligations. The difference between working capital and the current ratio is that the current ratio is presented as the proportion of current assets to current liabilities.
Calculation: Current Assets ÷ Current Liabilities
Interpretation: Let’s say Company XYZ has current assets of $100,000 and current liabilities of $50,000. This means the current ratio is $100,000 / 50,000 or 2:1 because current assets are twice as large as current liabilities. In general, investors look for a current ratio of around 2:1 as an indicator of solvency. A current ratio less than one means that a company may have difficulty covering its short term obligations and is a red flag.
You should compare your company’s current ratio to that of similar companies in the industry. It is also prudent to determine whether this measure has been increasing or decreasing over time. The same rule of thumb applies for all financial ratios in general.
Another name for the quick ratio is the acid test ratio. It is similar to the current ratio except that Inventory, Supplies and Prepaid Expenses are excluded.
The quick ratio can be calculated in 2 ways.
Cash + Marketable Securities + Current Receivables ÷ Current Liabilities.
Current Assets – Inventory, Supplies and Prepaid Expenses ÷ Current Liabilities.
Interpretation: The quick ratio can be viewed as a superior measure as compared to the current ratio because it removes inventory which is an illiquid asset (that is, inventory does not usually convert quickly into cash). A higher quick ratio is not only a good indicator for investors but also for creditors who can be more confident that they will be repaid in a timely manner.
Cash Asset Ratio
The cash asset ratio is also known as the cash ratio. It takes the quick ratio one step further by only including cash and marketable securities.
Calculation: Cash + Marketable Securities ÷ Current Liabilities.
Interpretation: The cash asset ratio is viewed as the most stringent measure of liquidity as compared to both the current and quick ratios. It is not commonly used when analyzing the fundamentals of a company because it is very rare that a business will keep its cash levels as high or equivalent to its current liabilities. Cash levels that are too high can even be viewed as poor asset utilization.
#3. Ways to Improve Liquidity
If your liquidity ratios are deteriorating over time, then it is time to take swift action. Here are some ways you can improve liquidity:
- Reduce your overhead.
- Get rid of unproductive assets.
- Cut back on owner’s draw (the amount of profit distributed to the owner).
- Improve receivables by offering discounts to customers who pay early.
- Manage payables better by taking advantage of flexible payment terms wherever possible.
For more tips on managing your payables and receivables, please see our previous blog post.
Final Thoughts on Understanding Liquidity Ratios
Liquidity is important because it underscores operational efficiency in the short run and can impact profitability in the long run. Liquidity ratios are the key to evaluating this impact for your business.
Remote Quality Bookkeeping does not recommend doing the books on your own unless you are a professional accountant or bookkeeper because it often leads to erroneous reporting and the potential for IRS audits. In addition, doing the books yourself takes you and your team away from focusing on your core operations.
That said, we believe it is important to have a keen understanding of the meaning behind your numbers in terms of measuring performance and setting business goals for the future.
Don’t hesitate to contact the team at RQB today for help with your business needs.