4.6. Liquidity ratios

Current ratio

Companies have limited assets with enough liquidity to be converted into cash to pay the liabilities. Those current assets which include cash, bank deposits, debts and receivables could be easily converted into funds. The current ratio measures the ability to pay short-term financial obligations through short-term assets, thus it is an important measure of short-term liquidity. As such this is a concept that binds the concepts working capital and working capital requirement.

  • \(Current\ ratio=\frac{Current\ assets}{Current\ liabilities}\)

The current ratio helps investors and equity holders to identify its capacity to pay these commitments, thus avoiding shortages in cash: A ratio above 1 indicates that the company has more current assets than current liabilities.

The liquidity ratio is also indicative of the debt burden: if the company has a low liquidity ratio and has a significant debt burden, it means that future cash flows will potentially be used to pay debt service.

Example case: Dutch Fabric Innovations

Let’s focus on the items in the table below, extracted from DFI’s balance sheet:

Values in EUR
 2020 2021 2022 2023 2024
Current assets 148 131,29 1 026 339,69 2 321 331,19 4 869 230,98 9 120 978,46
Current liabilities 193 510,78 801 104,23 1 687 673,67 2 755 238,33 4 246 202,37
Current ratio 76,54% 128,11% 137,54% 176,72% 214,80%

With a value of current assets equal to 148 131,29€ and current liabilities equal to 193 510,78€, DFI has a Current Ratio of 76,54% in 2020:

  • \(Current\ ratios=\frac{148\ 131,29}{193\ 510,78}=76,54\)%

After 2020, the current ratio increases and is always above 100% which indicates that from 2021 it has more current assets than current liabilities and is more and more capable of complying with its short-term obligations.

Example case: Golden Days

Let’s consider some items of Golden Days’ balance sheet:

Values in USD 2019 2020 2021 2022 2023
Current assets 132 602,39 369 230,24 770 755,60 1 016 934,44 1 317 923,41
Current liabilities 24 712,32 59 135,81 187 004,89 225 306,77 268 746,66
Current ratio 536,58% 624,37% 412,15% 451,35% 490,39%

With a value of current assets equal to 132 602,39$ and current liabilities equal to 24 712,32$, in 2019 Golden Days has a Current Ratio of

  • \(Current\ ratio=\frac{132\ 602,39}{24\ 712,32}=536,58\)%

All the 5 years present values for this ratio above 100%, meaning that the company has more current assets than current liabilities and, as a result, has a strong short-term liquidity and a great ability to pay short-term obligations. This motivates possible investors to actually invest in the company with the guarantee that Golden Days is able to avoid cash shortages.

After 2019, the current ratio decreases as a consequence of bigger growth of current liabilities in comparison with the growth of current assets.

Quick ratio

Reduced liquidity is similar to general liquidity, however the current assets considered to be capable of being converted into cash is shorter: it is considered that inventories do not have sufficient liquidity for short term cash flows. Additionally, because inventories are essential for the normal productive cycle of the company, constant level of inventory may be required. Reduced liquidity resulting from this assumption that inventories cannot be converted into cash and cash equivalents short-term financial. As a result, reduced liquidity will always be lower than the General liquidity. It is a more demanding test to the company’s short term capabilities.

  • \( Quick\ ratio=\frac{Curret\ asset-inventory}{Current\ liabilities}\)

Another (stricter) way to define reduced liquidity ratio is through considering only the current assets that can be converted to cash within 90 days. These may include cash and bank deposits, short-term investments or marketable securities and accounts receivable are considered. Short-term investments or marketable securities include trading and available for sale that can be easily converted to cash within 90 days.

Example case: Dutch Fabric Innovations

Let’s focus on the items in the table below, extracted from DFI’s balance sheet:

Values in EUR 2020 2021 2022 2023 2024
Current assets 148 131,29 1 026 339,69 2 321 331,19 4 869 230,98 9 120 978,46
Inventories – 179 543,83 387 713,83 742 031,50 1 162 836,98
Current liabilities 193 510,78 801 104,23 1 687 673,67 2 755 238,33 4 246 202,37
Quick ratio 76,54% 105,70% 114,57% 149,79% 187,41%

DFI presents no inventories in 2020, but this changes from 2021 on. For example, in 2022 we have:

  • \(Quick\ ratio=\frac{2\ 321\ 331,19-387\ 713,83}{1\ 687\ 673,67}=114,57\)%

Example case: Golden Days

Let’s consider some items of Golden Days’ balance sheet:

Values in USD 2019 2020 2021 2022 2023
Current assets 132 602,39 369 230,24 770 755,60 1 016 934,44 1 317 923,41
Inventories – – – – –
Current liabilities 24 712,32 59 135,81 187 004,89 225 306,77 268 746,66
Quick ratio 536,58% 624,37% 412,15% 451,35% 490,39%

Golden Days has no inventories so the quick ratio is equal to the current ratio, that is,

  • \(Quick\ ratio=\frac{132\ 602,39-0}{24\ 712,32}=536,58\)%

Much like the Current Ratio, the Quick Ratio indicates that the company has a great capacity of dealing with its short-term obligations with its most liquid assets. For example, in 2019, the ratio tells us that the company has around 5,36$ of current assets ready to be transformed into cash and to cover each 1$ of its current liabilities.

Next Section: 4.7. Receivables and payables