Liquidity Analysis RatiosTax Professionals' Resource
October 23, 2012 — 1,260 views
Liquidity Analysis Ratios
The financial health of a company can be measured many different ways using its financial statements. Businesses' asset activity, profitability, and relative total debt level are all commonly assessed using ratios. Line items from the balance sheet and income statement are compared with one another using percentages, creating a level playing field for the comparison of companies of all sizes within an industry.
Financial statement analysis is not, however, only used for external comparisons. It can also be used to assess a company's internal health. In any industry, the phrase "cash is king" applies to all short term operations. No matter how profitable a given business model might be in the long term, a company that can't sustain itself in the present will likely come to an unfortunate and untimely demise. In other words, companies must have enough liquid assets to cover short term liabilities on the balance sheet and operations expenses on the income statement to survive in a competitive environment. To determine whether a business can do this, liquidity analysis ratios involving information from financial statements have been developed and ubiquitously adopted among investors, firms, and analysts.
As with all other forms of ratio analysis, each formula is ultimately just a fraction. The numerators of liquidity analysis ratios are almost always a combination of short term assets. Similarly, the denominators are typically different combinations of short term liabilities and operating expenses.
The "quick ratio" is perhaps the most well-known of all liquidity analysis formulas. Its numbers are easy to find, and it gives the analyst or investor a good idea of where the company stands in terms of its ability to meet short term debt obligations. To find it, one must simply divide the sum of cash, accounts receivable, and short term investments by current liabilities, which is essentially all interest and principal payments due within one year.
The other liquidity analysis formula commonly used is a little less conservative. Known as the "current ratio" it is calculated by adding inventory to cash, accounts receivable, and short term investments in the numerator and dividing by current liabilities.
As with any type of financial statement analysis, proper context and a good understanding of company operations is necessary to make good use of liquidity analysis numbers. If, for instance, a company is notoriously slow or inconsistent in collecting on its accounts receivable, the current and quick ratios might give an overly optimistic estimate of its actual liquidity. But regardless of their potential shortcomings, liquidity analysis calculations can be very useful tools in determining the short term financial stability of a business.