A company’s liquidity ratio is a measurement of its ability to pay off all of its 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.
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 total 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 the debts and outstanding liabilities it has incurred.
A low liquidity ratio could signal the 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 currently available 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.
Improving 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.
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.