“If you want to reap financial blessings, you have to sow financially.” - Joel Osteen
Whether you are a start-up owner with 10 employees on your team or a million-dollar company with hundreds of employees, tracking your finances is crucial. We all know that tracking finances is not a piece of cake but all you need is a systematic way to get the job done. This is where the financial ratios of your business can effectively assist you.
To continue, as there are so many measurable KPIs for measuring financial performance, it often gets difficult to keep track of everything at the same time. But, there are 5 types of financial ratios that can also precisely do the job more efficiently. The 5 ratios are liquidity ratios, leverage ratios, efficiency ratios, profitability ratios, and market value ratios.
To continue, although every financial ratio holds its own importance, the liquidity ratio is the most prioritized as this ratio will ensure that you are not operating your business on edge. But, before getting into that, it is essential to understand what exactly are liquidity ratios.
To define, liquidity ratios are the measure that defines the companies’ capability to pay off their debts. The capabilities are measured in terms of both, long-term as well as short-term obligations. Further elaborating, liquidity ratios define how quickly a company can liquify its assets to clear out all the dues.
Keeping the track of liquidity ratio is important because it allows businesses to understand whether they will be able to pay off their obligations in case of emergency or crisis. These ratios will give an assurance to the businesses whether they would be able to pay out their bills without any stress.
Now that we are clear on the definition and importance of the liquidity ratio as an important aspect of financial management, it's time to understand the different types along with their formulas and examples.
4 Types of Liquidity Ratios With Examples
1. Current ratio
The current ratio is also known as the working capital ratio can be defined as the company’s capability to pay off its short-term obligations or debts with its current assets. This short-term period is usually 12 months. The current ratio varies from industry to industry but the average of every industry lies between 1.0 and 3.0. The current ratio that lies between the number or is higher than the number, implies that the company has a good current ratio. However, below the average current ratio indicates a high risk of losses or distress. Below mentioned is the formula that can be used to calculate the current ratio.
Formula - Company’s Current Ratio = Current Assets/ Current Liabilities
Let’s assume that you are an owner of a manufacturing company, and the value of current assets for the year 2022 was 20 Million. Additionally, the cost of current assets was 13 Million. So, as per the formula,
Current ratio = 20/13 = 1.53
So, the current ratio of the company will be 1.54 which according to the average current ratio is totally acceptable.
2. Acid-test ratio
The acid test ratio is also called the quick ratio which determines the company’s ability to pay off its current liabilities using its current assets. All types of cash or cash equivalents, marketable securities, and accounts receivable are added to the assets while calculating the acid test ratio. The ideal acid test ratio should be equal to 1 because less than that would indicate that the company is not earning enough to pay off its liabilities.
In fact, it should not be even more than 1 because it will indicate that the cash if the company is resting idly instead of getting invested somewhere profitable to enhance the profit margin of the company. The formula for the calculating acid test ratio is given below.
Formula - Acid-test ratio = (Cash+Marketable Securities+AR)/ Current Liabilities
Where AR : Accounts Receivable
Let’s assume that your manufacturing unit had total cash of 2 million, your marketable securities were a total of 2 million, and your accounts receivable of almost 4 million in a year. Whereas, your total current liabilities of that same year were 4 million. So, as per the formula, your acid test ratio would be,
Acid test ratio = (2+2+4)/4 = 2
This implies that you have a good acid test ratio of your company that is equal to 2 which means that you will easily be able to pay off your debt when required.
3. Cash ratio
The cash ratio is the measure of the company’s capability to pay off all its obligations with either cash or its cash equivalents which might include all the marketable securities as well. An ideal cash ratio of a company should be equal to or greater than 1. Compared to other liquidity ratios, the cash ratio is comparatively narrowed because this liquidity ratio is only based on the generated cash or the cash equivalents. The formula for the cash ratio is given below.
Formula - Cash Ratio = Cash + Cash Equivalents / Current Liabilities
Let’s assume that the cash that you generated in a particular year was 8 Million and your cash equivalents are equal to 4 million. Besides, the liabilities that you need to pay off are 4 million. So according to the formula, the cash ratio of your company would be,
Cash Ratio = (8+4)/ 4 = 3
This implies that your company has a good cash ratio. In fact more than the ideal ratio which means that even if you have to repay your obligations, you are still successfully attaining your business objectives.
4. Operating cash flow ratio
The last but not the least type of liquidity ratio is the operating cash flow ratio. This form of liquidity ratio assists in measuring the total number of times the company can pay off its liabilities from its cash generated from a specific period of time. If the number is more than one, this implies that the company was successful in earning more than needed to pay off its current liabilities. The formula for calculating the same ratio is provided below.
Formula - Operating cash flow ratio = Operating cash flow/Current liabilities
Let’s assume that your company successfully generated 19 million in a certain year and the liabilities of that corresponding year were 6 million. So, as per the calculations, the operating cash flow of your company would be,
Operating cash flow ratio = 19/6 = 3.1
This indicates that with your generated cash, you can pay off the same amount of your current liabilities 3 times and still you have some amount left with you. This implies that you are successfully heading towards enhanced business growth.
To encapsulate, keeping track of your finances is one of the inevitable duties that you need to perform in order to make your business successful. Hence, you should always ensure that you track your financial ratios effectively. Moreover, the above-given liquidity ratios will assist you in taking care of your business’s financials in terms of paying off your liabilities.