Liquidity ratio analysis refers to the use of several ratios to determine the ability of an organization to pay its bills in a timely manner. This analysis is especially important for lenders and creditors, who want to gain some idea of the financial situation of a borrower or customer before granting them credit.
There are several ratios available for this analysis, all of which use the same concept of comparing liquid assets to short-term liabilities. These ratios are:
- Cash ratio. Compares the amount of cash and investments to short-term liabilities. This ratio excludes any assets that might not be immediately convertible into cash, especially inventory.
- Quick ratio. Same as the cash ratio, but includes accounts receivable as an asset. This ratio explicitly avoids inventory, which may be difficult to convert into cash.
- Current ratio. Compares all current assets to all current liabilities. This ratio includes inventory, which is not especially liquid, and which can therefore mis-represent the liquidity of a business.
Though it can be useful to engage in liquidity ratio analysis, the results can lead one to be overly optimistic or pessimistic about a potential borrower or creditor, for the following reasons:
- Timing. There may be a cash inflow or outflow that falls just outside of the requirements of a ratio (being stated as a long-term asset or liability) that could have a severe impact on the target entity. For example, there may be a balloon payment on a loan that due in just over one year, and so is not classified as a current liability.
- Seasonality. The balance sheet information upon which these ratios are based may be entirely different in a few months, if the entity is subject to seasonal influences.
- Bad debts and obsolescence. The accounts receivable and inventory in different versions of the liquidity ratios can include varying amounts of assets that will never be converted into cash. If so, they will skew the results of these ratios to give the target entity an enhanced appearance of liquidity that is not really the case.
In short, this type of analysis can yield misleading results. To avoid this issue, conduct a more detailed analysis of the assets and liabilities of a business, with particular attention to the collectability of specific receivables and an examination of the age of the inventory.