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Firstly, let us begin with the liquidity ratios which are measures to determine the company’s ability to pay off current debt.
What are Liquidity Ratios?
Liquidity ratios measure the ease at which a company meets its short-term financial obligations from its current assets. It helps the investors and creditors to understand the company's liquidity position. It depicts how easily the company will be able to pay off its current liabilities through its current assets.
The different types of liquidity ratios include:
1. Current Ratio:
The current ratio is the ratio of current assets (cash, inventory, accounts receivable) to its current liabilities (obligations due in the next twelve months such as bills payable, share of long-term debts due for payment, etc).
A current ratio of 2: 1 is considered ideal. However, this rule of the thumb varies from industry to industry. Higher the current ratio, better it is as it signifies higher liquidity (i.e., a greater ability to meet short-term obligations). However, a very high current ratio is also not good because this signifies that the company has blocked too much of its productive resources into current assets.
A lower current ratio signifies less liquidity and inability of the company to meet its short-term obligations. A current ratio of 1.0 implies that the book value of current assets is equal to book value of current liabilities.
Once again, this is not a thumb rule as there are companies like ITC and Hindustan Unilever that have a current ratio of less than one for more than the last three to five years and still they are financially stable.
This is because a very low current ratio or a current ratio of less than one signifies that the company is actually underpaying its suppliers compared to what it is receiving from its customers and thus utilizing this supplier’s money as its own equity to grow the business further.
2. Quick Ratio:
Quick ratio is a more stringent measure of liquidity than the current ratio because it does not include inventories and other assets that might not be liquid. It includes only more liquid current assets (known as ‘quick assets’) in relation to current liabilities. The higher the quick ratio, more likely it is that the company will be able to pay its short-term bills (i.e., greater liquidity).
This ratio reflects the fact that the inventory might not be easily converted into cash and the company may not be able to sell its inventory at the carrying value when needed urgently. The inclusion of accounts receivable is not a hard and fast rule. If there is evidence that it cannot be converted into cash quickly, then it can be excluded from the calculation of quick ratio.
Marketable securities are short term debt instruments, typically liquid and of good credit quality and should be considered in calculation of quick ratio.
3. Cash Ratio:
The most conservative liquidity measure is cash ratio. Only highly marketable short-term investments and cash are included in the ratio. The higher the cash ratio, the more likely is that the company will be able to pay its short-term liabilities
While creditors prefer a higher cash ratio, managers endeavor to reduce the cash ratio without impairing the operating efficiency of the company. This is because too much of resources blocked in terms of cash is a sign of inefficient capital deployment (this is because cash is a negative yielding asset whose purchasing power decreases)
Even from a creditor's perspective, increase in the other liquidity ratios may not necessarily be an encouraging sign; slow-moving and non-moving inventories may increase the current ratio but that does not signify improvement in the liquidity of the company.
4. Operating Cash Flow Ratio:
This ratio measures whether a company is able to meet its obligations from the cash flow generated out of its operations. Decrease in current assets and increase in current liabilities increases cash flow from operations.
Therefore, current ratio and cash flow from operations ratio move in opposite directions with change in current assets and current liabilities.
Let’s calculate liquidity ratios from the following information: -
Given, Cash Flow from Operations = ₹52,190
1) Current Ratio = Current Assets/ Current Liabilities
2) Quick Ratio = (Current Assets – Inventories)/Current Liabilities
3) Cash Ratio = (Cash + Marketable Securities)/Current Liabilities
4) Operating Cash Flow = Cash Flow from Operations/Current Liabilities
There are few other important liquidity ratios that can be used to determine the current debt repaying capacity of a company in case of banks-
- Credit to Deposits (%)
- CASA (%)
- Interest Expended to Total Funds (%)
- Interest Income to total Funds (%)