Degree of Relative Liquidity
The Degree of Relative Liquidity, also known as the Liquidity Ratio, is a measure of a company’s ability to meet its short-term obligations using its short-term assets without raising external capital.
There are several types of liquidity ratios, each measuring liquidity in a slightly different way:
- Current Ratio: This is calculated as a company’s current assets divided by its current liabilities. A higher current ratio indicates a higher degree of liquidity.
- Quick Ratio: Also known as the acid-test ratio, this is calculated as a company’s most liquid assets (cash, marketable securities, and accounts receivable) divided by its current liabilities. It’s a stricter measure than the current ratio because it excludes inventory and other current assets that are not as easily converted to cash.
- Cash Ratio: This is the most conservative liquidity ratio, calculated as a company’s cash and cash equivalents divided by its current liabilities. This ratio measures a company’s ability to pay off its current liabilities with just its cash and cash equivalents.
- Working Capital Ratio: This is calculated as current assets minus current liabilities. A positive working capital ratio means a company has enough short-term assets to cover its short-term debt.
Each of these ratios provides a slightly different perspective on a company’s liquidity. In general, higher liquidity ratios indicate that a company is more likely to be able to meet its short-term obligations, which can be a sign of financial health. However, very high liquidity ratios can also indicate that a company is not using its assets efficiently to generate profits. As with all financial ratios, these should be used in context and in conjunction with other financial analysis tools.
Example of the Degree of Relative Liquidity
Let’s consider a simple example using some of the liquidity ratios:
Suppose we have a company, we’ll call it XYZ Corp. Here are some of its financials:
- Current Assets: $500,000
- Of which, Cash and Cash Equivalents: $100,000
- Marketable Securities: $50,000
- Accounts Receivable: $150,000
- Current Liabilities: $300,000
Now, let’s calculate some liquidity ratios:
- Current Ratio = Current Assets / Current LiabilitiesCurrent Ratio = $500,000 / $300,000 = 1.67
- Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current LiabilitiesQuick Ratio = ($100,000 + $50,000 + $150,000) / $300,000 = 1
- Cash Ratio = Cash and Cash Equivalents / Current LiabilitiesCash Ratio = $100,000 / $300,000 = 0.33
These ratios tell us that:
- The Current Ratio of 1.67 means XYZ Corp has $1.67 of current assets for every $1 of current liabilities. This suggests that XYZ Corp has more than enough short-term assets to cover its short-term liabilities.
- The Quick Ratio of 1 means XYZ Corp has $1 of easily liquidated assets for every $1 of current liabilities. This suggests that even without selling any inventory, the company can cover its short-term obligations.
- The Cash Ratio of 0.33 means XYZ Corp has $0.33 in cash and cash equivalents for every $1 of current liabilities. This suggests that the company doesn’t have enough cash on hand to meet its short-term liabilities, but keep in mind that this is a very conservative measure of liquidity.
Remember, while these ratios can provide useful insights, they should be used in conjunction with other financial ratios and analysis methods to get a complete picture of a company’s financial health. Also, it’s helpful to compare these ratios with those of other companies in the same industry, as what might be considered a healthy ratio can vary between industries.
