Ratio Analysis and Interpretation: Liquidity Ratios

To judge the overall financial health of a company, analysis of some ratios from the financial statements can prove to be useful. 

Ratio analysis is used to evaluate the relationship between financial statements. Various ratios can be used to identify trends over time for one company or to compare two or more companies. Additionally, ratio analysis helps you judge all the companies on the same metrics, despite the differences between their volumes of sales, the costs that they incur, etc.

Ratio analysis can be used for the following purposes:

• To evaluate performance over time
• To evaluate performance against industry average
• To evaluate performance against peers

There are four categories of ratios that will help you perform a critical evaluation and delve deeper into the figures mentioned in the financial statements. The categories are as follows:

1. Liquidity Ratio
2. Solvency Ratio
3. Profitability Ratio
4. Efficiency Ratio

Liquidity ratios:

Every company needs money to conduct its day-to-day operations. From small expenditures, such as stationery to big expenditures, such as corporate functions and meal packages, the company has to ensure that such operations run smoothly.

It is important to have some portion of the net worth in liquid assets. Liquid asset refers to the assets that can be quickly converted into cash as per requirement. The functions of liquidity ratio are as follows: 

• It assesses a company’s ability to pay off short-term debts using current assets.
• It assesses a company’s ability to procure loans.
• The higher the ratio, the better it is for the company. 

There are two types of liquidity ratios that are as follows: 

Current ratio: This metric is used to measure a company's short-term liquidity. In other words, it analyses whether a company is able to pay its short-term borrowings using its current assets. 

It is calculated using the following formula:

Current ratio = current assets / current liability

The higher the ratio, the better it is for the company.

Quick ratio: It measures a company’s ability to meet its short-term obligations using its most liquid assets.

The only difference between quick ratio and current ratio is that quick ratio excludes inventory from the current assets, as raw material first needs to be converted into finished goods, which further needs to be converted into cash. 

It is calculated using the following formula:

Quick ratio = (Cash and cash equivalents + Short-term investments + current receivables)/Current liabilities 

Note: The formula may differ slightly based on the situation. However the logic behind the quick ratio, "a company’s ability to meet its short-term obligations using its most liquid assets", remains the same. The formula to calculate Quick ratio is:: 

Quick Ratio = (Current investments + Trade receivables + Cash and  cash equivalents + Short term loans and advances + Other current assets) / Current liabilities

The higher the ratio, the better it is for the company.

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