A liquidity ratio is a measurement which is used to indicate whether a debtor will be able to pay their short-term debt off with the cash they have readily available, or whether they’ll need to raise additional capital to cover the amount. This kind of metric can also show how swiftly the assets held by the debtor can be turned into cash for the debt.
Key takeaways from this section:
- Liquidity ratios are types of ratios that show a company’s ability to pay off short-term debts from its cash.
- There a number of different liquidity ratios that creditors and debtors use to establish metrics about the liquidity of a business and its coverage of short-term debts.
- Liquidity ratios can give an idea of the financial health of a business, though they’ll rarely tell the whole story. Full analysis is needed to establish a full picture of the state of a company’s finances.
Understanding liquidity ratios
When we talk about liquidity, we’re talking about how quickly or easily a company’s assets can be turned into cash without losing their value. The more liquid the assets of a business, the more quickly they can get cash to pay off their debt.
Liquidity ratios are what creditors (and sometimes debtors) use to work out if a company can repay creditors from the total cash they have available. The higher the liquidity ratio is for that company, the more liquid their assets are and the more able they’ll be to pay off short-term debts.
There are a number of different liquidity ratios that can show the status of the debtor – these include:
- Current ratio
- Quick ratio
- Operation cash flow ratio
- Working capital
- Working capital ratio
- Absolute liquid ratio.
When used in conjunction with each other, these metrics can give a comprehensive overview of how likely it is that the debtor can pay of their debt without raising extra capital.
What are the different kinds of liquidity ratios?
The most common liquidity ratio used is the current ratio. The current ratio gives an indication of the company’s ability to pay off current debts using the entirety of the assets the company has available.
The formula for working out the current ratio looks like this: Current Ratio = Current Assets ÷ Current Liabilities. If the current ratio is higher than 1.00, it means the cash available covers the short-term liabilities.
Another much-used liquidity is the quick ratio or acid test ratio. Unlike the current ratio which takes into account all of the assets of a company, the quick ratio focuses on the business’ quick assets - that is to say, highly liquid assets that can be turned into cash swiftly and without losing too much of their book value.
The formula for this kind of liquidity ratio is: Quick Ratio = Liquid Assets ÷ Quick Liabilities. As with the current ratio, a quick ratio of higher than 1.00 means that the full debts can be paid. We’ve also written a full guide on quick ratios to give you a better idea.
Liquidity Ratio FAQs
What is the difference between a liquidity ratio and a solvency ratio?
The biggest difference between a liquidity ratio and a solvency ratio is the time and length of the debts and obligations in question.
As we have seen, a liquidity ratio deals with short-term or current loans – giving an indication of a business’ ability to deal with those short-term obligations. They show the liquidity of the company’s assets.
Solvency ratios deal with the long-term view, which includes long-term debts and the complete array of financial obligations that a business can have.
What is a good liquidity ratio?
If your liquidity ratio for your business is higher than one, then your company is in good financial shape and will be able to take on financial challenges in the future. The higher the liquidity ratio, the healthier your businesses finances will be.
Anything below one and you should be considering strategies to improve the way your business works to keep yourself financially protected.
What are the three main types of liquidity ratio?
While there are a number of different kinds of liquidity ratio you can calculate for your business, the most common ones are the current ratio, the quick ratio and the cash flow ratio. Using a combination of these three liquidity ratios can provide a clear look at the performance of your business from a financial perspective.
Have you thought about Invoice Finance as a cash flow solution for your business?
Invoice finance allows you to release cash quickly from your unpaid invoices.
As your lender, we can release up to 90% of your invoices within 24 hours. On payment of the invoice from your customers, we will then release the final amount minus any fees and charges. There are different types of invoice financing options available to businesses depending on the situation and the level of control they require in collecting unpaid invoices.
We are an invoice financing company who offer a solution whereby payments are collected on your behalf managed by our team of expert credit controllers so you can focus on running your business. Our Confidential Invoice Discounting solution is offered to businesses who want to maintain their own credit control processes, therefore this remains strictly confidential so your customers are unaware of our involvement.
The benefits of invoice finance companies such as Novuna Business cash flow
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Competent staff, slick technology. Would recommend
Halo is one of the smartest bits of tech I have seen & every team is only as good a it's people and I would like to take this time to actually specifically point out Alex Hall & Claire Davies. Alex is an account manager that has continually improved during our time working together and is a real credit to Novuna. Claire has been exceptional from start to finish; meticulous in her work and very patient with us at every temp - an absolute star. It is a shame that the email address went to a generic platform and not each individual. I totally understand why this works better for companies but it did mean that the personal element was lost meaning that starts like Claire will be harder to identify from a customer point of view.
High recommedation for Novuna Business Cashflow.
My company was in need of invoice factoring to assist with the cashflow due to the nature of debtor days with our clients. After looking at a number of options, the right decision was made to work in partnership with Novuna Business Cashflow. Right from setup through sales to customer service, the communication and support has been outstanding. Providing me with all the information I needed regarding new clients coming onto our books. The system they use is so user friendly and the drawdown payments are very efficient in the fast moving world of temporary payroll. This has allowed my company to look at positive growth knowing we are safe financial hands. I would highly recommend Novuna Business Cashflow 10/10.
Set up went well and communication was good.
Syed and Vipul were extremely helpful top class service
Very helpful from the start
Great people made this process very straightforward.
Jemma from Novuna (formally Hitachi) was brilliant. Worked with us throughout the process and succeeded when some others had failed. Carried out the necessary checks with a smile and cheery demeanour, making what would have been a laborious process quite manageable.
Teething problems -Maybe ?
It's still early days so I may alter this review at a later date. However with retentions and concentration limits and other items, were finding were not getting 85% up front, were probably getting nearer 70% Also when a customer pays the remaining allegedly 15% due to us seems not to be credited to become available. For instance a customer paid Â£6918 and a customer paid Â£1300 hence we should see an extra Â£1330 available (15% of both these payments). However availability seemed to go down and not up by Â£1330 !!! Hard to work out where this 15% has actually gone ? I'll re-submit this review when things become clearer.
I found Hitachi true to their world in every aspect of the service they promised. I can't recommend enough.
Excellent Customer care and service.
Excellent customer service from start of initial conversations, right through to finally becoming a customer. The whole team involved are a credit to Hitachi, they were accommodating and informative the whole way along the process. I would highly recommend Hitachi to future clients and business associates. Thanks Alan.
I really enjoyed working with the Hitachi team, professional, helpful and really good people to deal with. They have made what could have been a very difficult experience a pleasure. Very happy to recommend them.
Hitachi made the process of moving factoring facilities painless, bearing in mind we previously had our facility with the same provider since 1997. I cant fault Hitachi's staff and processes and we are delighted with the move.
Staff excellent all together professional
Great service so far
From start to finish the process for transferring our invoice finance to Hitachi has been been brilliant, a smooth transition, great communication our link Person Jonathan Oakes has helped the process go through seamlessly, A great experience so far and a brilliant start to what we hope will be a long term partnership.