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.
- 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.