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?
There are basically 4 types of liquidity ratios; here we will explain how you can calculate them. Continue below!
Current ratio
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).
As we have seen in previous topics, liquidity ratios are extremely useful tools to understand if the enterprise has sufficient resources. However, attention must be paid when monitoring them so as not to make mistakes.
In addition to knowing what they are and how to calculate them, you must understand well the methods behind this type of evaluation. In many cases, the financial department is responsible for doing this initial analysis of the ratios. It will also create the financial reports that will help complement the monitoring.
What is important at this time is to group this information with the data taken from the ratios, always focusing, of course, on the indicators that are related to the company’s current goal. For example, if it is a short-term goal, current liquidity ratio, if long term, overall liquidity ratio.
Thus, with the data grouped and organized, it is time to make comparisons with old information and with established goals. Here is the chance to assess whether the company is better than before or if it has achieved its growth goals.
An important point of this monitoring is that the more automated the process, the better. Using management software is the most appropriate alternative if the goal is to make this monitoring mechanism more intuitive and practical, including in data collection and comparison of indicator results.
In general, business management software, including indicator management, can bring several benefits to the company. In this topic, we list the three main ones.
Imagine a company that has a considerably great pace of inputs and outputs. Now think that the monitoring of its finances is done only by employees, without any technology.
It is undeniable that there is a great probability of errors occurring in the collection and analysis of information. It is also an activity that will take up unnecessary time that could be used for another activity.
With management software, in addition to the time optimization, as everything is done in a programmed way, the possibility of errors is null. After all, the efficiency in collecting and monitoring data is done in an automated way, saving employees’ energy and directing them to pay attention to what really matters.
For a company that does not have software to aid in its financial management, the cost of taking care of its management while also monitoring its behavior is very high. This is because it will need to hire more manpower to manage and collect data, in addition to dealing with employees.
However, by acquiring software, in addition to automating this process, there is a reduction of expenses, since it is no longer necessary to hire people. After all, it will do all the activities quickly and efficiently.
By acquiring management software, the company will have access to different data. As we explained earlier, it will be crucial for the correct collection and management of this information.
That way, it is possible to be aware of how the business behaves and to understand what needs to change for the enterprise to improve, knowing exactly what are the strengths and weaknesses of company’s strategies.
Well, this article has tried to shed light upon what the liquidity ratios are and how you can monitor and calculate them. Do you want to keep learning with our exclusive content? Then subscribe now to our newsletter!
