A company’s patrimony goes far beyond its results and its profitability. Its assets include, for example, machinery, real estate, investments, etc. All of this can be transformed into capital, which can help your company invest or pay creditors. Knowing this, it’s very important for a business leader to know how to calculate the liquidity ratio for each of your company’s investments.
This article will explain more about this topic, which is fundamental to the financial health of any company. Let’s get started?
What after all is a liquidity ratio?
It’s a financial indicator that shows how many resources a company has. This makes it possible to understand how much debt your business can withstand. Every investment has a different degree of liquidity. A building, for example, has low liquidity, or in other words, it isn’t possible to transform it into capital quickly.
In order to calculate a liquidity ratio, a business leader needs to consult the sum of a company’s resources. This way it’ll be clear whether the company has enough assets to honor its obligations. A company can perceive that it doesn’t have enough solvency to expand its operations, for example.
The greater a company’s liquidity, the greater it’s financial health. For example: if the result is greater than 1, this means that the business has a good capital margin, and can pay its debts without compromising its investments.
If the result is very close to 1, this means that the company has just enough to honor its debts, and will not have any resources left over after eliminating them.
If the result is zero — or lower— this means that the company doesn’t have enough to pay its creditors. This is a preoccupying situation.
How do you calculate the different types of liquidity ratios?
The current ratio focuses on the short term. That’s why to calculate it you need to consult the company’s current assets and its immediate financial obligations.
The formula is as follows: current assets / current liabilities.
Quick liquidity ratio
With an even greater focus on the short term, the quick liquidity ratio excludes your product inventory, because this calculation just considers the resources that your company already possesses. The quick liquidity ratio is therefore lower than the current liquidity ratio.
Its formula is: (current assets – inventory) / current liabilities
Cash asset liquidity ratio
Unlike the other liquidity ratios that we’ve cited, this calculation doesn’t take into account current assets, but just the financial resources that the company already has, or in other words: the company’s bank balance, cash and financial investments with immediate liquidity.
We calculate it by using the following formula: available assets / current liabilities
Caution must be used to analyze this index. Having more money in your bank account than your current liabilities is not always a positive thing. Depending on external factors such as inflation, these resources can lose their value.
Overall liquidity ratio
With a focus on the long term, the overall liquidity ratio takes into account the resources that the company already has, as well as those that will come. The same is done for the liabilities. The data necessary to calculate this index is found in the balance of your company’s patrimony.
Calculating it is simple: (current assets + long-term assets) / (current liabilities + long-term liabilities).
Having access to the correct information is fundamental to selecting which liquidity ratio is most appropriate for your company. That’s why you should use technology to store financial information about your business. Also remember that these calculations complement other financial studies.