All business owners should have a working knowledge of the financial benchmarks which represent the financial health of their business. Today’s article will be about liquidity ratios.
Liquidity Ratios are used to measure the quality and adequacy of current assets to meet current obligations as they come due. There are numerous ratios but really there are two that matter the most to a business owner and a potential external lender.
• Current Ratio – Indicates the extent to which current assets are available to satisfy current liabilities. Usually stated in terms of absolute values (i.e., 2.5 to 1.0 or simply 2.5).
• Formula: Current Assets / Current Liabilities
• Quick Ratio – Indicates the extent to which the more liquid assets are available to satisfy current liabilities. Usually stated in terms of absolute values. A quick ratio of 1.0 generally is considered a liquid position.
• Formula: (Cash and cash equivalents short term investments net trade receivables)/Current Liabilities
• Days of Cash – Indicates the number of days revenue in cash. Generally 7 days is considered adequate.
• Formula: (Cash and cash equivalents) * 360 / Revenue
Why are these liquidity ratios so important? First, they represent assets that a company needs to operate on. A Current Ratio of less than 1 means there are greater current liabilities than there are current assets to pay them. However, since some current assets are less liquid than others, the Quick Ratio considers the most liquid of the current assets and excludes current assets like inventory which is harder to turn into cash. The higher the quick ratio, the more cash a business has to pay its obligations and maintain safety cash.
The last ratio I mention is days of cash. It is measured in a whole number indicating the number of Days of Cash a business has to operate given its current revenue rate. This benchmark is an excellent planning benchmark for businesses. A business should maintain a safe level of safety cash in addition to the cash it needs to operate daily. Seasonal businesses need more days of cash going into a peak season then they do coming out of one. Cyclical businesses should also pay close attention to the Days of Cash Benchmark and plan for up and down ticks in revenues.
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