Liquidity Measurement Ratios

As we continue our educational articles we want to focus on an investment strategy area which many investors use when accessing a potential company to invest in, this area is called liquidity measurement. Liquidity measurement comes with a set of ratios that measure a company’s ability to pay off its short-term debt obligations. This is an important aspect an investor needs to look at because this is indication if a company has enough liquid assets(cash included) to be able to pay off its debts, if this is negative this can mean a company is prone to bankruptcy which has a negative impact on the price of a share. As an investor you never want to put your money where a company is uncertain of its ability to pay off its debt and this always raises a red flag with investor if a company has low liquidity ratios. This article will look at four liquidity measurement ratios which are namely the current ratio, quick ratio, cash ratio and cash conversion.

1. Current Ratio: The current ratio is the most used and probably the most important liquidity measurement. This ratio checks if current assets are able to cover current liabilities. The way you get the current ratio is by taking the total of current assets /current liabilities. The basis behind this ratio is to investigate whether a company’s current assets (cash, marketable securities, cash equivalents, inventory, debtors to the company etc.) is readily available to pay short term debts. Looking at results a healthy current ratio ranges between 1-2:1, as an investor you do not want a current ratio that exceeds 2.5 because that shows that a company is sitting on too much when they should be expanding the company or returning money to shareholders as a form of dividends.
2. Quick Ratio: The quick ratio is a refined current ratio and is a liquidity indicator that only measures the most liquid current assets (which is mainly cash) of a company’s ability to cover it’s current liabilities (short term debts). This ratio is calculated by (cash, cash equivalents, invested funds short-term investments)/current liabilities. In terms of results a healthy quick ratio is between 0.75-1:1 anything below 0.5 should be worrying for an investor because that shows that the company is not liquid or essentially does not have current assets that can easily turn into cash.
3. Cash Ratio: the cash ratio is an indicator that further refines both the current and quick ratio by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover the short-term debts. This ratio is calculated by(cash,cash equivalents, invested funds)/current liabilities. In terms of results a cash ratio of between 0.3-0.5:1 is a healthy ratio.
4. Cash Conversion: this last liquidity measurement expresses the length of time a company uses to sell its inventory, to collect its debts and pay its debtors. It is a bit complex to get that many investors do not like to use it as it takes time as usually as investors reading the notes underneath financial statements can give you an idea of a cash conversion and how quick a company generates cash.

In conclusion, the first three liquidity measurement ratios are the most important and a lot of investors use the first three to compare between companies. Also another thing to note about these ratios the result averages can be industry specific for an example for banks their industrial current ratio average might be 2.5 whereas for industrials it might be 1.1. As an investor when checking on the health of liquidity ratios be sure to check the industrial average first. There is always news about a company's cash position and you can use the ZimStocks App to keep track of the latest news.