KPI of the Day – Accounting: # Liquidity ratio
Measures the available cash or other assets easily convertible into cash that could cover short-term payables. Short-term payables represent the total amount of payments forecasted between zero and three months, from the time of the calculation.
To assess the program or institution’s capacity to pay its short-term claims and expense obligations.
It may prove rather difficult to benchmark an organization’s health on liquidity ratios. On the one hand, a high ratio commonly indicates a large amount of cash on hand, maintaining a high liquidity ratio for a long period of time may prove inconsistent with the company’s need for growth.
On the other hand, companies with low ratios might find it difficult to meet their financial obligations, placing themselves at risk of default.
Liquidity ratios can be seen as a way to use financial statements to glean information on how well a company can pay its short-term bills. The three most common of these ratios are the current ratio, quick ratio, and cash flow ratio.
A. The current ratio is defined as current assets divided by current liabilities – both available from the balance sheet.
B. The quick ratio, which is similar to the current ratio, only takes into account what the company can use to pay off its current liabilities as fast as possible.
C. The cash flow ratio offers an indication of whether or not a company has enough money from its current operations to pay off its current liabilities. Liquidity measures can be static (spot historical position) or predictive (projected over a one-year horizon).
The best practices for organizations to consider when basing their decisions on liquidity ratios would be:
- Analyzing ratios based on historical trends and top competitor achievements for this indicator;
- Consider ratios in relation to other key performance indicators such as cash conversion cycle;
- Taking both accounts receivables and accounts payable into consideration when trying to achieve high liquidity ratio targets;
- Measuring key performance indicators such as the # Defensive interval alongside liquidity ratios; the # Defensive interval or the # Defensive interval ratio (DIR) measures how long a company can survive with no cash coming in.
As a final note, you should keep in mind that interpretations for # Liquidity ratio are varied and they highly depend on the available data for this KPI. Stockholders look at liquidity ratios as part of a company’s investment strategy. Banks and lenders, in general, make their credit extension decisions based on the same liquidity ratios.
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