What is the Degree of Relative Liquidity?

The degree of relative liquidity (DRL) is a liquidity metric that examines a company's ability to support short-term expenditures. The degree of relative liquidity is determined by looking at the total percentage of cash a company has on hand.

The cash must be earned through regular operations and able to be spent on expenses and short-term debt obligations through a specific period. Companies that possess a higher degree of relative liquidity will probably have less difficulty in retrieving funds for payments.

Key Takeaways

  • The degree of relative liquidity is a metric that examines a company's ability to pay near-term expenses.
  • The degree of relative liquidity is similar to current ratio, as both measure the ease in which a company's cash flow or assets can be used to satisfy liabilities.
  • Investors should keep an eye on liquidity metrics, as they indicate whether a company could be facing long-term financial issues.

Understanding the Degree of Relative Liquidity (DRL)

As with all liquidity metrics, indications that a company is barely able to make short-term payments can be a sign the company could be facing serious financial issues in the long term. Financial distress as a result of the inability to make debt payments could lead to bankruptcy.

The degree of relative liquidity is similar to the current ratio. Both measures offer an indication of the relative ease with which cash flow or assets can be used to satisfy liabilities.

Cash flow from normal operations is rather subjective in nature. Different businesses will and should recognize revenue sources differently. For example, a widget manufacturer shouldn't recognize income from ancillary sourcessuch as the sale of an assetas ordinary or standard revenue. Whereas a museum which charges admission but runs a gift shop will recognize revenues from merchandise sales, as this would be considered part of a typical operating model for a museum.

This means no two industries (and sometimes even companies from the same industry) have the same revenue recognition and expense recognition methods. Hence, it wouldn't be unusual for an analyst to adjust financial items to standardize the degree of relative liquidity ratio.

Beyond standard internal decisions, at times—such as during an economic slowdown—external factors can lead to a deterioration in financial conditions at a company. This in turn can weaken a company's degree of relative liquidity, even though this is largely out of the control of management.