what you need to know about this economic indicator

What is the liquidity ratio?

First of all, it is necessary to understand what liquidity is. It is simply defined as the ability of a  company to transform its assets into cash to meet its short-term debts.

Based on this concept, we can say that the liquidity ratio is a financial indicator that indicates precisely the ease with which an organization can or cannot convert its assets into a means of payment. All this with the purpose of evaluating the financial health of the business and determining how solvent it is considering its debts.

Importance of liquidity ratio for startups and SMEs

Understanding, calculating and analysing your company’s liquidity ratio is essential, as it allows you to know certain aspects of your management that you can improve to deal with any unforeseen events. In this way, the indicator provides you with information to make informed decisions that help you maintain your business for longer.

Other aspects to consider are:

• The indicator is essential for the early stages of survival of new companies, as it allows you to know whether or not you are able to meet the operating expenses of the business in its early stages.
• It allows you to determine whether the company can begin to invest in its growth or the development of new products. Remember that, without a stable financial base, accelerated business growth becomes unsustainable.
• Having a healthy liquidity ratio helps you get new investors or even loans from banking institutions. This is one of the first indicators that economists evaluate to know how your business is doing.

Components of the liquidity ratio

Before calculating the liquidity ratio, you need to understand some basic concepts that are part of the equation. These include current assets and current liabilities, which are defined as follows.

Current assets

Current assets are all the assets and rights that a company has that can be converted into cash in less than a year. It is from these assets that short-term obligations (12 months or less) are covered.

We can classify current assets into three categories:

1. Treasury assets : These are the most liquid resources owned by the company, as they represent the money held directly in cash or in its bank accounts. This means that they are the resources that can be accessed in the shortest time.
2. Inventory assets : This category includes all products that the company has in its inventory and which are expected to sell quickly. Materials available to produce goods or services also fall into this category.
3. Cash assets : Finally, these are assets such as accounts receivable, securities that can be traded with investors or even credits. The important thing in these cases is that the cash can be generated in less than a year.

Current liabilities

In contrast to the previous case, current liabilities represent all short-term obligations or debts. This includes accounts payable, debts with suppliers, tax payments, and loan payments, among others.

Having a large number of these liabilities reduces the company’s liquidity and can affect its financial health. If this is combined with having few current assets, then the business does not have the capacity to borrow and runs the risk of declaring bankruptcy in the event of unforeseen situations.

Types of liquidity ratios

Now that you know what the liquidity ratio is, you need to learn how to use the different variants that exist. Each type of ratio is differentiated by including or excluding one of the components we talked about above (current assets and liabilities).

From this, we obtain several types of ratio that you need to know:

• This allows us to know what proportion of the obligations are covered by the business’s working capital.
• Defensive liquidity ratio : Finally, we have an indicator that compares liquid assets with the operating expenses of the organization. All this with the aim of knowing if the company can continue to operate without sacrificing other assets.

In general, the calculation of each liquidity ratio is very similar and is based on the same equation, which we will see later.

Each of these variants will yield results that may be greater than one, equal to one, or less than one. However, it is important to note that the analysis of these results varies depending on the type of ratio and the information that the company needs.

How to calculate the liquidity ratio?

Let’s quickly look at how each of the liquidity ratios discussed in the previous section can be calculated. They are all based on the general ratio equation, which is calculated as follows:

Liquidity ratio = Current assets / Current liabilities

The equation is as simple as dividing current assets by current liabilities. Now, you need to make sure you have all the correct information when doing the calculation, so that the result is true and reflects the financial health of your business. Let’s see what the formula looks like for the other variants:

• Acid Test Ratio : Here you have to subtract the inventory (assets in stock) from the rest of the current assets and then divide by current liabilities:  Quick Liquidity Ratio = (Current Assets – Inventory) / Current Liabilities
• Absolute Liquidity Ratio – Now the calculation is based on using only the treasury assets i.e. cash on hand and funds in banks. Again this is divided by current liabilities:  Absolute Liquidity Ratio = Treasury Assets / Current Liabilities
• Working Capital Liquidity Ratio : In the numerator of the formula we use net equity, i.e. assets minus liabilities, and divide the result by current liabilities. To obtain the value in percentage form, we simply multiply the result obtained by 100:  Capital Liquidity Ratio = (Current Assets – Current Liabilities) / Current Liabilities
• Defensive liquidity ratio : Finally, to calculate this liquidity ratio, you saudi arabia email list have to put the treasury assets in the numerator and divide them by the operating expenses that the company has daily:  Defensive liquidity ratio = Treasury assets / Daily operating expenses

Practical examples of calculation

Here we are going to present three simple cases in which we will calculate the how to develop an ecommerce marketing strategy  general liquidity ratio for three hypothetical companies, and then learn how to interpret the results obtained.

Company #1

The financial data on current liabilities and assets can be obtained in this table:

From the totals we have sufficient data to calculate the liquidity ratio:

Liquidity ratio – Company no. º1 = €300,000 / €100,000 = 3

The result is greater than 1, so we can say that the company has good whatsapp number solvency, although the result is higher than ideal due to an excess of assets.