The Role of Liquidity Ratios in Stock Market Evaluation
Introduction
Liquidity Ratio are financial ratios that are used to assess a company's ability or liquidity to meet its short-term obligations. Liquidity ratios can be used by investors and analysts to evaluate the financial health and operational efficiency of a company.
Method of Analyzing Liquidity
A company's liquidity is analyzed by evaluating the company's liquid assets that can be easily converted into cash against the company's short-term liabilities which the company needs to meet on its daily operations.
Generally, If the liquid assets are more than the company's short-term liabilities, then it indicates that the company is performing well and the company is able to pay its debts on time. If the liquid assets are less than the company's short-term liabilities, then it indicates that the company is finding it difficult to generate cash to meet its debt and day to day operations. These are signs for investors to understand the company's operational efficiency and how well it's meeting its debts and short-term obligations.
The investor can understand that irrespective of the company's long-term assets , quality products or services. The question of how the company will pay its debts ,if not paid, will lead to bankruptcy of the company in near term.
Fundamental Liquidity Indicators
The key liquidity ratios that can be used by investors to analyse the company's liquidity strengths are current ratio, quick ratio and cash ratio.
Current Ratio
Current ratio measures the company's ability to meet its short-term obligations or liabilities with its short-term assets. The short-term assets of a company are its cash, cash equivalents, marketable securities, trade and credit receivables and inventories which can be easily converted into cash.
Formula
Current ratio = (current assets/ current liabilities)
Example
Consider a company 'ABC' which holds liquid assets for Rs.500000 and its short-term liabilities is for Rs. 250000. Then the current ratio of the company can be calculated as
Current ratio = (current assets / current liabilities) = ( 500000 / 250000) = 2.0.
Inference
The current ratio value of 2.0 indicates that the company is holding liquid assets twice as much as its current liabilities. This indicates that the company has strong short term financial strength.
Quick Ratio
Quick ratio also known as Acid Test Ratio. This ratio excludes inventories from current assets since few companies cannot easily convert its inventories into cash easily. Quick ratio strictly measures the liquidity of the company without the need to convert the company's inventories into cash to meet its short-term obligations.
Formula
Quick ratio = ( current assets - inventory) / current liabilities
Example
Consider the above example a company ABC, which has inventories worth Rs.100000. Then the quick ratio of the company would be calculated as
Quick Ratio = (current assets - inventory)/ current liabilities = (500000 - 100000) / 250000 = 1.6
Inference
The quick ratio value of 1.6 indicates that the company is holding liquid assets without inventory 1.6 times as much as its current liabilities. This indicates that the company has strong short term financial strength.
Cash Ratio
Cash Ratio is considered as the most prudent liquidity ratio to measure the company's financial ability to meet its short-term obligations on considering only a company's cash and cash equivalents as current assets.
Formula
Cash Ratio = Cash and cash equivalents / current liabilities.
Example
Consider the previous example of a company ABC, which holds cash and cash equivalents worth of Rs.150000.
Cash Ratio = Cash and cash equivalents / current liabilities = (500000 -150000 ) /250000 = 0.6
Inference
The cash ratio value of 0.6 indicates that the company is holding cash and cash equivalents 0.6 times as much as its current liabilities. This indicates that the company can cover 60% of its current liabilities with its cash and cash equivalents .
Significance of Liquidity Ratios
Liquidity Ratios of value more than 1 indicate that the company is financially strong enough to meet its short-term obligations and operational day to day needs. This increases investors’ confidence on the company's performance and its stocks.
Creditors and lenders use these ratios to analyze the lending risk to a company. Liquidity ratios more than 1 indicate that the company is risk free.
Liquidity ratio indicates that the company has a strong operational efficiency and cash management practices.
Conclusion
Liquidity ratios are essential fundamental tools used in financial analysis of a company and its stocks. Liquidity Ratios provides insights on the company's ability to meet its short-term obligations. By calculating a company's current, quick and cash ratios , investors and analysts can understand the financial strength and operational efficiency of a company. Liquidity ratios along with other financial ratios provide an in-depth view of a company's overall financial health which support investors in making investment decisions.
Frequently Asked Questions
Why is the Quick ratio called Acid Test Ratio ?
Quick ratio considers only the most liquid assets of a company excluding its inventories held by the company. This stresses the need for a company to maintain liquid assets that can be easily converted into cash to pay its debt.
What are the liquid assets that are considered as quick assets ?
Cash and cash equivalents, marketable securities, trade receivables and accounts receivables are considered as quick assets.
What does it mean if the quick ratio is less than 1?
When the quick ratio is less than 1, then it indicates that the company does not have enough cash to pay its debts, employees and suppliers. The liquidity crisis of 2007-08 on global credit crunch is one of the example crises met by company's when they maintain fewer quick assets.
What are Cash equivalents ?
Cash equivalents are short term liquid investments that can be quickly converted into cash. Examples are money market instruments like T-bills, repo agreements, marketable securities with maturity less than 3 months, commercial paper, certificate of deposit with maturity less than three months, bankers’ acceptance and G-secs.
What are Marketable Securities ?
Marketable Securities are quickly convertible financial instruments held by companies for a short term . Example T-bills, short term bonds, commercial paper etc...
Disclaimer: This blog is dedicated exclusively for educational purposes. Please note that the securities and investments mentioned here are provided for informative purposes only and should not be construed as recommendations. Kindly ensure thorough research prior to making any investment decisions. Participation in the securities market carries inherent risks, and it's important to carefully review all associated documents before committing to investments. Please be aware that the attainment of investment objectives is not guaranteed. It's important to note that the past performance of securities and instruments does not reliably predict future performance.
