Liquidity ratio. What is it and how do you calculate it?
As we have been indicating in our previous articles, since the pandemic it has been possible to appreciate a greater interest in the field of corporate treasury and also a greater demand for specialization in the sector. Until a few years ago the sector was not so attractive, or at least it did not receive much attention. Currently, however, many companies are rethinking a review of their treasury and cash control practices. In addition, the evolution of financial technology “Fintech” is allowing the irruption of innovative software companies that, by automating payments between companies (B2B), and greater real-time access to balance sheets and treasury movements, allow Have greater control and visibility of the cash situation of the companies. Additionally, they allow hundreds of hours to be saved in tedious and manual processes that add little added value to companies. These innovative programs allow finance and treasury teams to focus on higher value-added tasks and financial analysis.
Within those metrics specialized in the field of treasury, and which, as we said before, are increasingly taken into account, we find the liquidity ratio. For its focus on the short term.
Liquidity ratio, formula
The liquidity ratio is equivalent to: Liquidity ratio = Current Assets / Current Liabilities. Or as we can see more graphically below.
Liquidity ratio, description
In short, the objective of the liquidity ratio or “current ratio” is to analyze the situation of a company in the short term. The formula, which tries to compare is the amount of goods or liquid assets that a company has against its short-term debts, in order to determine the ability of a company to meet its short-term debts. Let us remember that, in the field of accounting, the short term generally refers to a period of 1 year or what is the same, the next 12 months. Everything that exceeds that period is usually classified as long-term, both on the asset and liability side.
On the other hand, what is taken into account when calculating short-term assets? In the first place, cash is recognized as short-term assets, both physical (bills that may be kept in the company, or in the physical cash of certain businesses), although it is less and less common, and the money existing in the company bank accounts. On the other hand, within current or short-term assets we also find short-term investments, which are liquid, that is, they can be disinvested immediately or in a short period of time and therefore allow cash to be available in the event of to need it. To give an example, an investment in shares of a listed company whose shares are in the public market, would be considered a current asset, because a company could sell those shares any day and obtain their value in exchange. However, an investment in an unlisted family business or startup whose shares cannot be sold immediately would not qualify as current assets.
On the liabilities side, current liabilities would be made up of all those short-term payments from suppliers, social security, taxes, fees, etc. As well as any maturity related to the indebtedness of the company, such as financial expenses or amortization of the principal of the bank debt that the company has.
Interpretation of the liquidity ratio
As you can imagine, the liquidity ratio is a very important ratio in the financial field, since the repercussion of having a more or less high ratio is very important. To demonstrate healthy liquidity, as a general rule, the liquidity ratio has to be around 1, and it is more recommendable that it be above 1. What does this mean, for example? A ratio of 1 would mean that for every Euro of short-term assets, we have one Euro of short-term debt. Therefore, the company has sufficient liquid assets to meet its short-term debts. However, as you can imagine, there is no margin for error. In other words, unless there is any payment to suppliers, payment of taxes or any other extraordinary event, this ratio could be affected and harm the company’s ability to pay any of its short-term maturities.
Let’s take the case of a company that has 1,000 euros of current assets and 10,000 euros of current liabilities. The ratio resulting from a company in this situation would be 0.1. As may be obvious, the result of this extreme scenario clearly shows that the company is not in an adequate liquidity situation.
On the other hand, let’s take the example of the opposite scenario. Let’s imagine a company that has 10,000 euros of current assets and only 1,000 euros of current liabilities. Would this scenario be very positive? A priori one might think that yes, that this company is in an optimal or exceptional liquidity situation. In other words, it has a lot of cash to be able to meet its short-term obligations. However, is this situation really optimal? Probably not. Unless there were long-term liabilities that were soon to become short-term liabilities because all maturities coincided in just over a year, that would probably not be an optimal situation either. A situation with a ratio of 10 like the one we are explaining would indicate that it is possible that resources are not being used efficiently, or that the company could carry out greater investments that would improve the performance of the company in the long term, instead of having an excess of cash in the company without obtaining any return.
Tips to improve the liquidity ratio
The liquidity ratio, as we said, measures the ability of a company to meet its maturities or short-term liabilities. To improve this ratio, there are a series of practices or actions that allow it to be improved and which we proceed to describe below.
Review of customer collection periods and payment periods to suppliers:
As this practice indicates, it is usually appropriate to periodically review these periods. First of all, you always have to try to improve the collection period. That is, collect as soon as possible. In this way, defaults are reduced and the short-term cash situation is greatly improved. On the other hand, while it is in everyone’s interest that supplier payments occur on due date, agreeing to a slightly longer payment period may allow companies to enjoy a margin for a few extra days or weeks. This is especially relevant for those companies with long production processes, or in companies in which the sales cycle is long. This is because the money from the sales is what finances the purchases, so the shorter the time gap between payments and receipts, the lower the need for financing.
Review of extraordinary payments:
Another of the most common ways to improve the liquidity ratio, or at least verify that it is being calculated correctly, is through a complete review of potential extraordinary payments. In other words, carry out an exhaustive review of social security payments, tax payments, rates, etc., to make sure that we do not leave out any important payment outside of the formula described above. Since these types of payments are usually mandatory, it is usually not possible to defer them or negotiate terms that obtain more advantageous periods. However, in the event that the ratio is adjusted and there is the possibility of renegotiating the terms, it is usually appropriate to discuss a potential renegotiation of the payment terms to be able to postpone a little the pending payments in the short term and that are damaging the ratio the most.
One of the most common ways to improve the liquidity ratio is by renegotiating the debt and its terms, especially those that mature in the short term. In fact, when companies find themselves in a delicate situation in the short term, this is usually one of the most common ways to turn the company around, as long as the creditors accept the new terms. What usually happens in these cases is that the debt is renegotiated, transferring part of the short-term debt to long-term debt, with the expectation that the company will improve in the future and have greater repayment capacity.
Increased sources of financing:
Another very common way to improve the liquidity ratio is by obtaining new sources of financing. In the event that this new source is also debt, the ideal way to improve the liquidity ratio is for this new debt to have long-term maturities, to provide that much-needed advantage in the short term. Another way to improve the ratio is by raising capital from “equity” investors, who do not have the obligation to repay other than through dividend distributions. Finally, it is usually ideal to also look for alternative sources such as subsidies, so that they also allow us to substantially improve the liquidity ratio.
Snab as a treasury tool that allows monitoring financial ratios and the liquidity position
Snab is a pioneer treasury cloud platform in Europe that helps precisely in each and every one of the functions and tasks related to treasury management and monitoring of the company’s cash situation. Snab serves first of all as a bank aggregation platform, allowing companies to access all their bank accounts in different banks and in different countries from a single place and with absolute independence, so that the financial team can consult their cash position and thus obtain part of the information necessary to calculate current assets. Snab also serves as a billing tool, that is, invoice receipt, scanning, and automatic registration of invoices. In addition, it is a payment and collection management tool, providing total control and visibility of accounts payable and receivable, since the platform has innovative technology that allows you to pay and collect invoices in one click, without having to leave the platform. This makes it possible to monitor the status in real time of all the company’s payments and collections, when calculating the ratio. Furthermore, Snab not only shows you alerts and helps you monitor the status of payments and collections, but also generates real-time treasury forecasts based on both historical and future information.