Just like individuals, businesses have bills to pay. A firm with sufficient liquidity is one that has enough assets available to cover its debt obligations. As an investor, this is an important measure you can use to estimate the risk of putting your money into a business because a firm that is clearly able to pay its bills is a much better risk than one that may not be able to service its debts.
Analysts use several ratios to assess a firm’s true liquidity. Each ratio makes use of specific information stated on the firm’s balance sheet. There are five specific items you should know to understand the liquidity ratios. Current assets include cash, cash equivalent assets (such as stocks that can be sold quickly) and inventory. Inventory means the goods a firm has on hand to sell. Current liabilities are short-term debt obligations. Total debt or total liabilities consists of all the debt obligations of a business, both short-term and long-term. Finally, stockholder’s equity or owner’s equity is the net worth of the firm after you subtract total liabilities from the firm’s total assets.
The current ratio is simply the firm’s current assets divided by the current liabilities. For example, if a firm has $100,000 in current assets and $40,000 in current liabilities, the current ratio is 2.5. The current ratio tells you how much is available to pay short-term debts. In this example, the firm has $2.50 for every $1.00 in short-term debt. Generally, a high current ratio is a good sign. However, if the current ratio is very high, it may mean the business has cash on hand that isn’t being efficiently used for expansion or investment.
A quick ratio is similar to the current ratio except that the value of inventory on hand is excluded from current assets. Inventory isn’t always as liquid as one would like. Excess inventory may indicate a problem with sales or with collecting from customers. In any case, it may not be easily convertible to cash to pay bills. The formula for a quick ratio is the current assets minus inventory, with the result divided by current liabilities. Suppose the firm in the preceding section has $80,000 in inventory out of $100,000 in current assets. That leaves only $20,000 in cash to pay short-term debts. If current liabilities equal $40,000, the firm actually has just $0.50 on hand for each $1.00 short-term debt. In this case, the firm may be at risk of not being able to pay its bills.
A final measure of a firm’s liquidity is the debt-to-equity ratio. Unlike the current or quick ratio, the debt-to-equity ratio gives you a measure of the firm’s overall or long-term debt situation. To obtain the debt to equity ratio, divide the firm’s total liabilities by the owner’s equity or net worth. Let’s ay a company has a net worth of $600,000 and total liabilities of $450,000. Divide the total liabilities by the net worth and you get a ratio of 0.75. This means the company owes $0.75 for each $1.00 of equity. The higher the debt-to-equity ratio, the more heavily in debt the company is, making it less liquid in the long term.