Liquidity ratios: what is it – Dictionary of Economics

Definition of liquidity ratios

The term liquidity has a double meaning: from a static point of view it can be defined as the position represented by current assets on the balance sheet in the form of cash or quasi-liquid assets easily convertible into cash (such as temporary financial investments). From a dynamic point of view, it refers to the company’s ability to generate said liquid assets with which to face payments at the right time.

Liquidity, as the capacity to generate liquid assets, has to do with the operating structure of the company, since it will have more capacity to generate money the shorter the cycle of supply – operation / transformation – marketing – collection. The generation of the necessary cash to face the payments has to fulfill two premises:

• From the dynamic point of view, the company must generate these liquid assets on time to be able to meet the payments when due.

• From a static point of view, the company should not have idle cash balances, since the opportunity cost for shareholders is high. Seeing that the money they invested is standing still without producing any return is a very bad sign, which, at the very least, will imply a censorship of the management team.

The methodology of liquidity analysis through the use of ratios is very widespread. Its popularity derives from its simplicity and speed when it comes to its application: it is enough to have data from two consecutive balance sheets to see how some items evolve in relation to others; and, in this way, inform us of the liquidity situation of the company.

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The ratios that study liquidity are referred to the analysis of the short and long term. Liquidity, in the strict sense, is a short-term concept, since it has to do with the materialization in money of the cycle of the company’s operations, which begins with the acquisition of merchandise or raw materials, and ends with the collection of of the sale of those, without or with transformation, depending on whether we are in a commercial or industrial company. However, the second group of ratios will guide us on whether the company can have sufficient assets to meet its long-term debts and on the financing structure of said assets (both on their demand and on the debt repayment periods). . For this reason, the three ratios included in this second group are called “long-term liquidity”, although this term is probably not the luckiest, being “solvency” more appropriate.

Short-term liquidity is measured through three ratios:

• General liquidity: Current assets / Current liabilities.

• Test – acid: (Current assets – inventories – non-current assets available for sale) / Current liabilities.

• Immediate availability or treasury: (Treasury + IFTs) / Current liabilities.

Long-term liquidity is measured through the following three ratios:

• Solvency: Total assets / Required liabilities.

• Self-financing: Net worth / Total assets.

• Coverage: (Equity + non-current liabilities) / Non-current assets.

As we pointed out earlier, when approaching the study of long-term liquidity ratios, we must understand this concept as the capacity that the company will have to face its long-term debts, looking specifically at the types of debts to which it must be paid. to deal with and in the assets invested with said funds.

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EXAMPLE

It is requested:

Carry out the analysis of liquidity ratios, both long and short term.

Solution:

The relationship of the results of the company’s liquidity ratios is as follows:

It should be noted that the company’s short-term liquidity, although the general liquidity ratio is not excessively high, does not seem to present a bad situation. The company has sufficient short-term assets to meet its current debts.

It is remarkable to see how inventories explain more than half of the weight of current assets, so that, after their deduction, we see that the company has no more than 0.57 euros in 20X1 to meet each euro of current debts.

If we also discount customers from the resulting asset, we see how the company, for each euro of debt, has a little less than twenty cents of liquid or quasi-liquid assets left to repay.

Analyzing the long term, we observe that the company has 1.72 euros invested in assets with which to deal with each euro that it owes to third parties, thus having improved the firm’s self-financing, which, however, is lower than 50 per 100.

As a positive point, we will add that the company has coverage of current assets of over 10%, showing a positive and growing working capital.

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