A company’s liquidity ratio is a measurement of its ability to pay off its current debts with its current assets. Companies can increase their liquidity ratios in a few different ways, including using sweep accounts, cutting overhead expenses, and paying off liabilities. However, if you're looking to do this, then it's important to note that a very high liquidity ratio isn't necessarily a good thing.
Key Takeaways
- Liquidity ratios measure the ability of a company to pay off its short-term obligations with its current assets.
- Two of the most common liquidity ratios are the current ratio and the quick ratio.
- A higher liquidity ratio indicates a company is in a better position to meet its obligations, but can also indicate that a company isn't using its assets efficiently.
- Ways in which a company can increase its liquidity ratios include paying off liabilities, using long-term financing, optimally managing receivables and payables, and cutting back on certain costs.
Understanding Liquidity Ratios
A company can calculate its liquidity ratio by taking the difference between liabilities and conditional reserves and using that figure to divide its current assets. This ratio can be a valuable metric for market analysts and potential investors in helping determine if a company is stable and financially healthy enough to pay off its debts and the outstanding liabilities it has incurred.
A low liquidity ratio could signal a company is suffering from financial trouble. However, a very high liquidity ratio may be an indication that the company is too focused on liquidity to the detriment of efficiently utilizing capital to grow and expand its business.
Two commonly reviewed liquidity ratios are the current ratio and the quick ratio. The current ratio examines the percentage of current assets a company holds to meet its liabilities, and it provides a good indication of a company's ability to cover its short-term liabilities. It's a measure of cash-on-hand that a company has to settle expenses and short-term obligations.
Another popular liquidity ratio is the quick ratio. This tool refines the current ratio, measuring the amount of the most liquid assets a company has to cover liabilities. The quick ratio excludes inventory and some other current assets from the calculation and is a more conservative measurement than the current ratio.
Increasing Liquidity Ratios
One way to quickly improve a company's liquidity ratio is by using sweep accounts that transfer funds into higher interest rate accounts when they're not needed, and back to readily accessible accounts when necessary. Paying off liabilities also quickly improves the liquidity ratio, as well as cutting back on short-term overhead expenses such as rent, labor, and marketing.
Additional means of improving a company's liquidity ratio include using long-term financing rather than short-term financing to acquire inventory or finance projects. Removing short-term debt from the balance sheet allows a company to save some liquidity in the near term and put it to better use.
Creditors analyze liquidity ratios when deciding to extend credit to a company. Typically, a liquidity ratio over 1 is considered good.
To improve a company's liquidity ratio in the long term, it also helps to take a look at accounts receivable and payable. Ensure that you're invoicing customers as quickly as possible, and they're paying on time. When it comes to accounts payable, you'll want to ensure the opposite—longer pay cycles are more beneficial to a company that's trying to improve its liquidity ratio. You can often negotiate longer payment terms with certain vendors.
The Bottom Line
A company's ability to pay off its obligations is an important measure of its financial health. A company that can pay its business expenses and pay down its debts through the profits it generates from its business operations and efficient use of assets is one that is likely to succeed and grow.
Liquidity ratios, which measure a firm's capacity to do that, can be improved by paying off liabilities, cutting back on costs, using long-term financing, and managing receivables and payables. That being noted, a higher liquidity ratio does not always indicate a stronger company, as it could reveal a company that is not managing its assets efficiently to grow its business.
FAQs
Liquidity ratios, which measure a firm's capacity to do that, can be improved by paying off liabilities, cutting back on costs, using long-term financing, and managing receivables and payables.
How can a company quickly increase its liquidity ratio? ›
Liquidity ratios, which measure a firm's capacity to do that, can be improved by paying off liabilities, cutting back on costs, using long-term financing, and managing receivables and payables.
How can a company improve its current ratio? ›
Improving Current Ratio
- Delaying any capital purchases that would require any cash payments.
- Looking to see if any term loans can be re-amortized.
- Reducing the personal draw on the business.
- Selling any capital assets that are not generating a return to the business (use cash to reduce current debt).
The Quick Ratio, also known as the Acid-test or Liquidity ratio, measures the ability of a business to pay its short-term liabilities by having assets that are readily convertible into cash. These assets are, namely, cash, marketable securities, and accounts receivable.
What increases liquidity in the market? ›
When the spread between the bid and ask prices tightens, the market is more liquid; when it grows, the market instead becomes more illiquid. Markets for real estate are usually far less liquid than stock markets.
What causes liquidity risk to increase? ›
Economic disruptions
Liquidity risk increases when such economic disruptions render businesses unable to meet cash flow and collateral needs under normal and stressed conditions.
What causes quick ratio to increase or decrease? ›
An increase in current liabilities will decrease both the current ratio and quick ratio if there is no change on the assets side. A decrease in current liabilities will increase the ratio if assets remain unchanged.
Which of the following will result in an increase in the quick ratio? ›
Answer and Explanation:
An increase in accounts receivable will raise the total value of the most liquid assets. Hence, the quick ratio will increase.
What is an increase in the quick ratio over time? ›
An increase in the quick ratio over time usually means that the company's liquidity position is improving and that the company is managing its short-term assets well. An increase in the current ratio over time always means that the company's liquidity position is improving.
What is an example of liquidity ratio? ›
A ratio of 1 means that a company can exactly pay off all its current liabilities with its current assets. A ratio of less than 1 (e.g., 0.75) would imply that a company is not able to satisfy its current liabilities. A ratio greater than 1 (e.g., 2.0) would imply that a company is able to satisfy its current bills.
Generally, a good Liquidity Ratio should be above 1.0. This indicates the company has enough current assets to cover its short-term liabilities. A higher Liquidity Ratio (above 2.0) shows the company is in a stronger financial position and may have spare cash available for investments or other opportunities.
How to solve liquidity ratio? ›
Types of liquidity ratios
- Current Ratio = Current Assets / Current Liabilities.
- Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities.
- Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.
- Net Working Capital = Current Assets – Current Liabilities.
In accounting terms, the quick ratio determines if a business's short-term (or current) liabilities – the amounts it owes in the coming three months – can be covered by its liquid assets. Liquid assets include cash and things that can be changed into cash within three months.
What is the quick ratio example? ›
Quick Ratio = (Current Assets – Prepaid Expenses – Inventory) / Current Liabilities. Suppose the quick ratio for a business is 4.5. This would indicate that the business has the repayment capacity of its current liabilities 4.5 times over utilising its liquid assets.
What are liquidity ratios current and quick ratios? ›
Both the quick ratio and current ratio measure a company's short-term liquidity, or its ability to generate enough cash to pay off all debts should they become due at once. Although they're both measures of a company's financial health, they're slightly different.
What leads to higher liquidity and higher profitability? ›
Working capital of a business refers to the excess of current assets (such as cash in hand, debtors, stock, etc.) over current liabilities. Working capital affects both the liquidity as well as profitability of a business. As the amount of working capital increases, the liquidity of the business increases.
How does quick ratio affect liquidity? ›
The quick ratio, also called an acid-test ratio, measures a company's short-term liquidity against its short-term obligations. Essentially, the ratio seeks to figure out if a company has enough liquid assets (cash or things that can easily be converted into cash) to cover its current liabilities and impending debts.
What makes a good liquidity ratio? ›
Generally, a good Liquidity Ratio should be above 1.0. This indicates the company has enough current assets to cover its short-term liabilities.
What does it mean if a company has a high liquidity ratio? ›
High liquidity means that a company can easily meet its short-term debts while low liquidity implies the opposite and that a company could imminently face bankruptcy.
