Liquidity is the ability of an entity to convert its assets into cash in order to settle its obligations, ideally with the lowest possible transaction costs. To do this, there are liquidity indicators that show the extent to which the company’s current assets in various forms cover its short-term obligations.
These types of indicators help evaluate the short-term financial position of the company. So let’s learn more about their characteristics and how to implement and measure them.
What are liquidity indicators?
Liquidity ratios are an important class of financial metrics used to determine a debtor’s ability to pay its current debt obligations without raising external capital.
These indicators help you understand your company’s ability to pay debts, obligations and its margin of safety through the calculation of metrics that include the current ratio, the quick ratio and the operating cash flow ratio.
How to calculate your liquidity ratio?
To calculate the liquidity ratio, you must look at the sum of the company’s resources. This will make it clear if you have enough assets to meet your obligations. For example, a company may perceive that it does not have sufficient solvency to expand its operations.
The greater the liquidity of a company, the greater its financial health. For example: if the result is greater than 1, it means that the company has a good capital margin and can pay its debts without compromising its investments.
If the result is very close to 1, it means that the company has just enough to cover its debts, and there will be no resources left over after eliminating them.
If the result is zero – or less – it means that the company does not have enough to pay its creditors. This is a worrying situation.
Types of liquidity indicators
There are basically 4 types of liquidity indicators; Here we will explain what they are and how you can calculate them:
1. Current ratio
The current ratio focuses on the short term. Therefore, to calculate it you must consult the company’s current assets and its immediate financial obligations.
The formula is as follows: current assets / current liabilities.
2. Quick liquidity ratio
With an even greater focus on the short term, the quick ratio excludes product inventories, as this calculation only takes into account the resources the company already possesses. The quick liquidity ratio is, therefore, lower than the current liquidity ratio.
Its formula is: (current assets – inventories) / current liabilities
3. Current asset liquidity ratio
Unlike the other liquidity ratios that we have mentioned, this calculation does not take into account current assets, but only the financial resources that the company already has, or what is the same: the company’s bank balance, treasury and financial investments with immediate liquidity.
We calculate it using the following formula: available assets / current liabilities
Care must be taken when analyzing this index. Having more money in the bank account than in current liabilities is not always positive. Depending on external factors of a company such as inflation, these resources can lose their value.
4. Global liquidity ratio
The global liquidity ratio takes into account the resources that the company already has, as well as those that will come, that is, it has a long-term approach. The same is done with the passive. The data necessary to calculate this index is found in the company’s equity balance sheet.
Calculating it is simple: (current assets + long-term assets) / (current liabilities + long-term liabilities).
How to monitor your liquidity indicators?
Liquidity indicators are very useful tools to know if the company has sufficient resources. However, you have to pay attention when monitoring them to avoid making mistakes.
In addition to knowing what they are and how they are calculated, you must understand the methods behind this type of evaluation. In many cases, the financial department is in charge of doing this initial analysis of the ratios. You will also create financial reports that will help complement the monitoring.
The important thing at this moment is to group this information with the data extracted from the ratios, always focusing, of course, on the indicators that are related to the current objective of the company. For example, if it is a short-term objective, the current liquidity ratio, if it is long-term, the global liquidity ratio.
Thus, with the data grouped and organized, it is time to make comparisons with the old information and with the established objectives. Here is the opportunity to evaluate whether the company is better than before or whether it has achieved its growth goals.
An important point of this monitoring is that the more automated the process is, the better. Using dashboard software will help you track liquidity indicators in a more intuitive and practical way.