Capital markets are cruel trading places where those with reliable information win and others lose. Unfortunately, the group of winners in any capital market is a small group, whether it’s stock market, crypto, etc. Therefore anyone who wants to become an investor or a trader should study various topics and be well-informed. That’s why in this article, we are going to discuss liquidity and liquidity ratio.
Understanding some topics such as liquidity and liquidity ratio helps you better estimate a company’s proficiency. Then, you can detect profitable companies from those that are not profitable. Liquidity ratios are financial metrics that investors use to determine a company’s ability to pay short-term debts.
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Now, let’s find out what liquidity is in the first place.
What liquidity ratio means?
You can’t understand what a liquidity ratio is if you don’t know about liquidity. Liquidity is a term that is frequently used amongst investors and traders. Therefore, it’s important for you to learn what liquidity is if you don’t already know.
What is liquidity?
If you want to understand what liquidity ratio is, you should first learn about liquidity. That’s why in this section, we are going to discuss liquidity. Liquidity is a financial metric they use in capital markets to measure a company’s financial aspect. On its own, liquidity is one’s ability to convert their assets to cash quickly.
They should be able to change their assets to cash quickly and in a cheap way. For example, when a company owns assets that are easily converted to cash, and it doesn’t take long, it has high liquidity. The more of these assets the company owns, the higher the liquidity ratio will be.
Liquidity ratio determines how much a company is able to pay its short-time debts. If a company’s liquidity ratio is high, it means that the company is financially healthy. This is because when a company is able to pay its short-time debts, the company is profitable. The ratio of liquidity is high for companies like these.
A company that isn’t able to pay off its short-time debts is not making enough revenue. Then, it is financially unreliable and therefore not healthy. These kinds of companies have a low ratio of liquidity. Then, analysts can easily detect companies’ financial health, to find the one’s that are a good opportunity to invest in.
How do you measure liquidity?
Analysts use the liquidity ratio formula to measure the company’s liquidity. There are three kinds of liquidity ratios. Each of these liquidity ratios measures a different aspect of liquidity. Therefore, there are three different liquidity ratio formulas for each of them.
In the next section, we will discuss what those three different ratios of liquidity are. Then, we will also take a look at each of the liquidity ratio formula.
What are the 3 liquidity ratios?
There are various ratios of liquidity that indicate different things about a company’s financial state. In this section, we will discuss each one individually and will take a look at each liquidity ratio formula.
This liquidity ratio measures the company’s ability to pay off debts in a year. They measure it by calculating different variables such as the company’s cash, inventories, and accounts receivable.
The current liquidity ratio formula is current assets / current liabilities.
The Quick Ratio
In the quick ratio, they don’t count inventories as assets. This is because they want to calculate all of the quickest company assets. Then, the quick ratio shows the company’s ability to pay off short-term debts.
The quick ratio liquidity ratio formula is C + MS + AR + CL / CL.
C means cash, and CL is current liabilities. ML is marketable securities, and AR is accounts receivable.
Day Sales Outstanding
The Day Sales Outstanding measures how long it takes for companies to receive payment after they sell. If the DSO is high, it means that it takes longer for the company to receive payment. Then, it takes longer to increase liquidity.
The DSO liquidity ratio formula is the Average accounts receivable / Revenue per day.
What is a good Liquidity Ratio?
As you read above, the liquidity ratio defines one’s ability to pay debts. Then, we should find what a good ratio is for a company. A good ratio of liquidity above 1 is good for the company. This means that if a company’s liquidity ratio is 1:1 or above, such as 2:1, it means the company is financially healthy.
On the other hand, a bad liquidity ratio is below 1. If a company’s liquidity ratio is below 1:1 it means the company is having a hard time paying off its debt. Then, a company that can’t handle its short-time debts can’t be profitable.
Is high liquidity good?
Yes. High liquidity indicates that the company can handle its debt. As we mentioned above, low liquidity indicates that the company can’t pay off its debt. That alone is a red flag because for any reason, the company has bad financial health.
On the other hand, high liquidity shows that the company is financially strong enough to pay its debts. That’s a good sign for those of you who are looking for stocks to invest in.
What are examples of liquidity ratio?
On this website, we will check out Apple’s liquidity ratio as an example.
Here it shows current assets and current assets. It also shows the Current Ratio of Apple’s liquidity. If you scroll down, you will find other kinds of information and measurements for Apple liquidity.