May 1, 2023

How to Look at Liquidity through an Accounting Lens

Liquidity refers to a business’s ability to convert its short-term assets or securities into cash quickly to meet its short-term financial obligations or pay bills due within the next 12 months. Naturally, cash is the most liquid. This is different than solvency, which refers to the ability of a business to satisfy its long-term bills.

It’s important to distinguish between market liquidity and accounting liquidity. Market liquidity implies how a nation’s stock market or real estate market functions, specifically if there are enough buyers and sellers. The closer the bid and ask prices are, the greater the level of liquidity that exists. The greater the liquidity, the easier it is for participants to transact.

Determining the liquidity of a business helps investors see how a company balances its cash. This demonstrates how well a company manages its ability to pay bills versus being able to direct money for retained earnings, dividends, reinvesting in its business, or for acquisitions. When it comes to measuring liquidity, there are three ratios that estimate how liquid a business is: current, quick, and cash ratios.

Current Ratio

This compares current assets to current liabilities. It’s expressed as follows:

Current Ratio = Current Assets / Current Liabilities  = $20,000 / $5,000 = 4

This means for every $1 in outstanding bills, the company has $4 in cash available to satisfy those debts. While each industry has a unique target ratio, a range of 1.5 to 2.5 is seen as a healthy measure.

Quick Ratio (Acid-Test Ratio)

This calculation removes inventories and some short-term assets that are more illiquid than incoming payments expected to be paid within a reasonable short-term time frame, such as accounts receivable. It’s expressed as:

Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities   

If the resulting number is less than 1, this could indicate the business is facing an inability to pay its short-term bills.

Cash Ratio

This looks at how well a company can pay off short-term debt with its cash and similar financial assets that can be converted to cash instantaneously. It’s expressed as follows:

Cash Ratio = Cash and Cash Equivalents / Current Liabilities = $10,000 / $3,000 = 3.33

With a 3.33 ratio, this example shows the company is in good shape liquidity-wise. A general reference of at least 0.5 (but higher shows better financial health) is recommended.

Interpreting Results

Once the results are calculated, businesses can analyze their findings and see the financial position of their company. For example, if they are looking for financing, lenders take into account these ratios to determine a level of confidence in debt repayment. If a company is looking for investors, savvy investors can determine how competitive the company is against its industry/sector competitors.

Internal Company Reflection

Depending on the company’s circumstances, changes might need to be implemented immediately and over the long term. A business may need to look at operating costs to cut costs. Cash flow projections are recommended to see how the company is doing on its restructuring and cost-cutting efforts.

When it comes to managing liquidity, using these ratios along with short- and long-term planning to improve a company’s financial and liquidity position can make a business more attractive to lenders and investors and more resistant to economic downturns.