The economic environment in which companies operate is more volatile and uncertain than ever. In addition to regulatory changes, there are new risks linked to cybersecurity, the global geopolitical situation, the social climate and low growth levels in many economies. Within companies, financial managers have an obligation to put in place an increasingly well thought-out financial and risk management strategy, in order to ensure their organization's resilience in the face of any new event.
While liquidity management must be carefully monitored in all circumstances, it is even more important in today's environment. Guaranteeing a company's solvency and being in a position to invest in its development are concerns shared by all decision-makers, for whom sufficient liquidity is a necessity. The liquidity ratio is therefore a key indicator.
What is the liquidity ratio?
The liquidity ratio is a financial indicator that measures a company's ability to meet its short-term debts - usually over one year - with its available assets. It therefore reflects an organization's financial solidity and its ability to operate without exposing itself to the risk of insolvency.
It is not, however, a guarantee of profitability, and should be used in conjunction with other indicators such as net margin, gearing or cash flow, to provide a more comprehensive picture of the effectiveness of financial strategy.
Generally speaking, the liquidity ratio must be analyzed in context, bearing in mind that a satisfactory ratio in one sector of activity may be qualified as a warning ratio in another. The evolution over time is also essential: a gradual deterioration in the ratio, even if it remains at a positive level, may reveal structural problems that need to be corrected as quickly as possible.
Liquidity ratio VS solvency ratio
The two concepts should be distinguished. While the liquidity ratio is concerned with the short term, the solvency ratio measures a company's ability to meet its financial obligations over the long term, and is therefore more of a strategic concern than an immediate danger.
What elements are used to calculate the liquidity ratio?
To be found in the balance sheet, the items to be included (and added together to calculate the total amount) fall into two categories:
Current assets
These are the financial resources available to the company in less than one year to pay its debts. They include :
- directly releasable cash, such as current accounts, sight deposits, cash on hand and highly liquid short-term investments (notably short-term Treasury bills);
- Trade receivables, which need to be closely monitored to avoid the risk of non-payment, or even late payment, which can impact cash flow. In this case, it is advisable to call on the services of a credit insurance professional to secure collection;
- Inventories intended for sale, as well as raw materials;
- Prepaid expenses, such as insurance or rent;
- Marketable securities, shares or bonds that can be resold quickly.
Current liabilities
These are debts that the company must settle within one year:
- Trade payables, due for the purchase of goods or services, usually payable within 30, 60 or 90 days;
- Borrowings and interest on borrowings to be repaid;
- Bank overdrafts, if any;
- Tax and social security debts (taxes, URSSAF, pensions, etc.);
- Payables to employees (salaries, bonuses, CP) or associates (dividends);
- Deferred income: advance payments received from customers for goods or services not yet delivered.
3 calculation formulas for greater visibility
Three different liquidity ratios can be considered, each providing a different perspective on a company's situation.
Current ratio
Encompasses all liquid assets and measures a company's ability to cover its short-term debts with all its current assets. To obtain it, simply divide assets by liabilities:
Current assets / Current liabilities = Short-term liquidity ratio
How should this figure be interpreted?
- A ratio greater than 1 means that the company has more current assets than current liabilities, which is a sign of good short-term financial health;
- If it is below 1, the liquidity ratio indicates difficulties in covering short-term obligations;
- If it is above 2, the ratio indicates an accumulation of unused liquid assets, which should be invested.
The restricted (or reduced) liquidity ratio
The restricted liquidity ratio, also known as the reduced liquidity ratio, is a financial indicator that measures a company's ability to repay its short-term debts without having to sell its inventories.
To calculate it, simply deduct the value of inventories from current assets, then divide by liabilities:
(Current assets - inventories) / Current liabilities = Current ratio
A healthy company will have a restricted liquidity ratio close to 1. If it's above 1, the company is able to cover its debts with instantly available cash. Below 1, the ratio indicates that inventories will have to be sold to achieve this. If the ratio is too low, e.g. below 0.5, there is a risk of over-dependence on the sale of inventories.
The quick ratio
The quick ratio is even stricter, taking into account only cash and short-term investments.
Cash + short-term investments (cash equivalents) / current liabilities = Quick Ratio
By focusing solely on cash that can be used directly, this ratio shows which debts can be settled without waiting for trade receivables to be collected or inventories to run off.
A ratio greater than 1 is obviously a sign of good health, but lower ratios are common, and the minimum acceptable ratio will vary according to the company's sector of activity. The shorter the collection cycle, the lower the acceptable ratio (as in the retail sector, for example).
What ratio should you aim for?
Determining the optimum liquidity ratio requires consideration of a number of factors specific to the company and the industry in which it operates. It is in the interests of a company's financial management to decide on the ideal ratio for its situation, based on one or other of the formulas, and to make it a long-term objective, a guideline that will act as a warning if too great a deviation appears.
Why monitor liquidity ratios?
A stable and regularly updated liquidity ratio is an integral part of a company's financial management, which has a number of benefits:
- The indicator makes it possible to anticipate cash-flow difficulties, by spotting tension at an early stage when the ratio has become too low, leaving the company vulnerable to unforeseen events.
- By guaranteeing stability, a good cash flow ratio strengthens the confidence of investors and creditors. This facilitates access to financing.
- Finally, resource management can be optimized on the basis of the information provided by the ratio: excessive liquidity, for example, reveals a misallocation of resources, which could be invested more productively.
Good liquidity management helps to minimize financial risks while seizing strategic opportunities. It is in the interest of every financial manager, in his or her own specific context, to make it a core element of management policy.
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