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How to calculate a company’s liquidity ratio using a formula? Also, recognize the types of liquidity ratios such as current, quick, and cash ratios.
Every company must be able to meet its financial obligations that must be met.
According to an expert in the book he wrote, the liquidity ratio shows the ability of a company to meet its financial obligations that must be completed immediately or the company’s ability to meet financial obligations when billed.
Therefore, every company must understand the liquidity ratio in the company’s financial records, which consists of several types, namely the current, quick, and cash ratios.
For more details, the following will explain how to calculate the liquidity ratio with several steps.
What is the Liquidity Ratio?
The liquidity ratio is a ratio that shows the company’s ability to fulfill obligations or pay its short-term debt.
This Ratio can be used to measure how liquid a company is.
Liquidity is the company’s ability to fulfill its obligations to pay its short-term debts that must be paid immediately using current assets such as accounts payable, dividend debt, tax debt, and others.
If the company can fulfill its obligations, it means that the company is liquid. In contrast, if the company is unable to meet its obligations, it means that the company is illiquid.
To measure whether a company is liquid, you can compare the components in the balance sheet, namely total current assets with total current liabilities (short-term debt).
This measurement can be done for several periods so that you can see the development of the company’s liquidity over time.
Usually, companies with high liquidity levels will have a better chance of getting various support from many parties, including financial institutions, creditors, and suppliers.
By knowing the company’s liquidity ratio, you can get several benefits, such as:
- Anticipate the funds needed when there is an urgent need.
- Facilitate customers (for financial institutions or banks) who want to withdraw funds.
- A deciding point for a company is to get approval for investment or other profitable businesses.
Types of Liquidity Ratios and How to Calculate Them
At this point, do you want to know whether your company has good liquidity?
To calculate this, you can use the liquidity ratio formula.
This calculation is divided into four types of liquidity ratios; what are they?
How to Calculate the Current Ratio
The current Ratio is the simplest way to calculate liquidity ratios compared to other methods.
This calculation is intended to determine the company’s ability to meet its short-term obligations with current liquid company assets or current assets.
This type of asset is an asset that can be exchanged for cash within one year.
The current ratio calculation formula is as follows:
Current Ratio = Current assets / Current liabilities
For example, a company has assets of $10,000 and current liabilities of $5,000.
So the company’s current Ratio is 10,000: 5,000 = 2,0
If the current ratio number of a company is more than 1.0 times, then the company can pay off its obligations. Because the Ratio of its assets is more significant than its liabilities.
However, if the current Ratio owned by the company is below 1.0 times, its ability to pay off debt is still questionable.
In addition, if a company’s current Ratio is more than 3.0, it does not mean it is in good financial condition.
The company is not allocating its current assets optimally, not utilizing its existing assets efficiently, and not managing its capital correctly.
How to Calculate the Quick Ratio
Quick Ratio is a further explanation of the Current Ratio.
The quick ratio calculation only compares the most liquid current assets with current liabilities.
Inventory is not included in the quick ratio calculation because it is difficult to exchange for cash, so the quick Ratio is much stricter than the current Ratio.
How to calculate the quick Ratio with the liquidity formula:
Short Ratio = (Current Assets – Inventory) / Current Debt
For example, the company has current assets worth $20,000, an inventory of $2,000, and current liabilities of $6,000.
Then the quick Ratio is ($20,000 – $2,000): $6,000,000 = 3.0
The result of calculating the quick Ratio, if it is more than 1.0, shows the company’s reasonable ability to fulfill its obligations.
However, when calculating the Ratio, the value is above 3.0 times, but it does not mean that the company’s liquidity situation could be better.
The company’s cash may be significant because it is not allocated anywhere and needs to be more productive.
Another reason is because of the high receivables of the company.
Quick Ratio can be used as a better reference because it focuses on current assets readily converted into cash.
The cash ratio is a way of calculating liquidity that involves the company’s cash.
The benefits are similar to the current and quick ratios, namely to determine the company’s ability to pay off its short-term obligations by using cash as a reference.
Here is how to calculate the cash-type liquidity ratio:
Cash ratio = (Cash + Securities) / Current debt
For example, a company has cash worth $5,000,000, securities worth $3,000,000, and current liabilities of $5,000,000.
Then the cash ratio is (5,000,000 + 3,000,000): 5,000,000,000 = 1,6.
Companies rarely use the cash ratio because it needs to be more realistic and easier to maintain its value.
The excess cash available to the company that can cover current liabilities is often considered unproductive cash that needs to be appropriately utilized.
Five items often used in calculating a company’s liquidity ratio value are current assets, current debt, cash, securities, and inventory.
The company needs a careful and precise accounting recording process to find out the final value of the calculation of these five items.
Cash Turnover Ratio
You can also calculate liquidity using the cash turnover ratio.
With this Ratio, you can see how many times the company’s cash rotates in one period assessed through sales.
To calculate the cash turnover ratio, below is the formula you can use:
Cash turnover ratio = Net sales / Average cash on hand
If this Ratio’s value is more significant, the company’s financial ability is also considered more important.
The rotating cash shows that the faster the money comes into the company.
This means that revenue is increasing so that cash for operational activities is also running smoothly.
The Benefits of Company Liquidity
Maintaining the level of liquidity is an important thing that the company must do.
By maintaining its liquidity, the company can gain the trust of internal and external parties.
For example, the internal party referred to here is an employee with a good level of liquidity; the company can pay employee salaries according to the specified date.
However, employee salaries may always be paid backward without paying attention to liquidity.
This will undoubtedly affect employee performance which will also affect the business development.
Meanwhile, for external parties such as suppliers, this liquidity can make external parties more confident in your company.
Not only for suppliers, you can also quickly get capital loans from banks, investors, and other parties.
The liquidity ratio is one of the company’s most critical ratios to succeed. It measures a company’s ability to meet its financial obligations that must be completed immediately or its ability to meet financial obligations when they are billed.
The liquidity ratio is a ratio that shows how much cash a company has on hand as compared to its short-term liabilities, which is often referred to as current debt. The balance is calculated by taking the total value of cash and securities and dividing it by the full value of current liabilities. A liquid company with a high liquidity ratio is often considered attractive to potential investors who use the balance to evaluate the company’s value.
Companies with high liquidity ratios are more likely to get funding from financial institutions such as banks and credit unions.
A high liquidity ratio only sometimes indicates good financial health, though.