Liquidity ratios are an indicator of whether a company can meet its payment obligations. Liquidity ratios 1-3 are used to measure short-term liquidity positions.
Definition: What are liquidity ratios?
Liquidity ratios are quantitative indicators with which the solvency of a company can be analyzed. They are determined by comparing assets with current liabilities. A distinction is made between three liquidity ratios: liquidity ratio 1 (cash liquidity), liquidity ratio 2 (collection liquidity) and liquidity ratio 3 (goods liquidity, also called working capital ratio).
What do liquidity ratios say?
Liquidity ratios are an important tool for determining the solvency of a company. Payment obligations include outstanding invoices and tax liabilities, but also rent payments or salaries.
If a company is liquid, it can meet its payment obligations at any time and in full. If this is not the case, it is illiquid (insolvent). It is threatened with insolvency.
What happens with too much liquidity?
However, the liquidity ratios do not only indicate whether there is a threat of insolvency. It may also be that a company has too much liquid assets - for example, money accumulated in a current account. In such cases, it makes sense to use these funds elsewhere, for example for investments in equipment or innovations.
Liquidity ratios: Balance sheet
The liquidity ratios are derived from the balance sheet. They therefore indicate the amount of liquidity at a specific, static point in time from the past.
The assets of a company are available at different speeds to settle current liabilities.
Depending on how quickly the assets can be mobilized and converted into cash and which values are included in the calculation, different degrees of liquidity are distinguished, more precisely: 1st, 2nd and 3rd degree liquidity. Thus, the classification of liquidity in terms of maturity matching is included in the analysis.
However, the key figure liquidity ratio does not give an absolute value, but rather the ratio of assets to current liabilities in percent.
Liabilities are considered current if they have a maturity or remaining term of up to one year.
Significance of the liquidity ratios
The liquidity ratios are used to determine an indicator of whether a company can meet its payment obligations.
The difference between the various degrees is that the higher the number, the more difficult it is to mobilize assets - i.e. they are characterized by a greater distance from money.
The significance and significance of the liquidity grades increases from 1 to 3. The 2nd degree liquidity is considered the most important liquidity ratio.
What does first-degree liquidity mean?
First-degree liquidity (also known as cash liquidity or cash ratio) is a measure of a company's ability to immediately settle short-term liabilities.
To calculate 1st degree liquidity, the ratio of liquid assets (i.e. cash on hand, bank balances or checks, securities) to short-term liabilities is calculated and then multiplied by 100.
Key liquidity figures: Reference value for 1st degree
If liquidity level 1 is exactly 100 percent, full coverage is given - all short-term payment obligations can be settled immediately and in full. Each open invoice can therefore be paid directly with money from the cash register or from the bank account.
Although this option is safe for the company, a high level of cash liquidity also means that the company cannot invest the liquid funds - so safety is at the expense of profitability. In other words: the proportion of liquid assets is too high at a value of 100.
As a rule, liquidity level 1 in companies is therefore significantly lower, usually around 20 percent. This still gives companies sufficient security to be able to meet their short-term payment obligations. At the same time, however, companies prevent the proportion of liquid assets from being too high.
What does second-degree liquidity mean?
The 2nd degree liquidity (collection liquidity or quick ratio) is determined by offsetting current liabilities with both cash and cash equivalents and current receivables.
The numerator is thus extended - compared to 1st degree liquidity - by funds that can be quickly converted into money; however, they are not available as quickly as cash in hand or funds in a current account. The value determined by the multiplication is also multiplied by the factor 100.
Second-degree liquidity indicates whether the short-term liabilities can be covered by the liquid assets and the short-term receivables. Short-term receivables mainly include trade receivables, but also receivables from affiliated companies.
Key liquidity figures: Standard value for 2nd degree
As a rule, it should be possible to settle short-term liabilities with the three items (cash and cash equivalents, securities and short-term receivables) promptly and in full.
Therefore, a liquidity ratio 2 of at least 100 percent is considered a guideline. This means that the sum of liquid assets and receivables should be as high as the sum of short-term liabilities.
What does the 3rd degree liquidity say?
The 3rd degree liquidity (liquidity of goods or working capital ratio) indicates the ratio of current assets to current liabilities.
A closely related indicator is working capital. It is calculated by deducting current liabilities from current assets.
What counts as inventories?
In the case of the 3rd degree liquidity - compared to the 2nd degree liquidity - the inventories are added to the liquid assets and the short-term receivables and again multiplied by the factor 100. Inventories include raw materials and supplies, work in progress and finished goods as well as advance payments made.
If the liquid assets and short-term receivables are not yet sufficient to cover short-term liabilities, the inventories of a company can be used. For example, to cash in on inventories, products can be made from raw materials and intermediate goods and then sold.
Key liquidity figures: Indicative value for 3rd degree
Target value for 3rd degree liquidity are values of at least 120 percent. Sometimes, however, values of 200 percent are also mentioned. The target value differs depending on the industry.
The value of 200 percent ("banker's rule" or "two-to-one rate") originates from the US banking industry. Overall, there is greater caution on the part of lenders with regard to the liquidity of companies - among other things due to accounting standards and a stronger orientation towards equity capital.
If, on the other hand, the value is less than 100, this means that the sum of short-term liabilities is greater than current assets - in other words, short-term liabilities cannot be covered.
However, a value of less than 100 does not necessarily mean insolvency: By taking out loans or increasing equity, liquidity can be restored to avoid insolvency.
Criticism of the liquidity ratios
Overall, the liquidity ratios do indeed provide important information on the liquidity of companies. However, only in themselves, their informative value is limited.
Major points of criticism are:
- The liquidity ratios only show the liquidity on the balance sheet date - and not at different, freely selectable points in time.
- The calculated liquidity ratios are often already out of date because the balance sheet is only presented months after the balance sheet date and the calculation is then based on these presented values.
- In addition, deriving the ratios from the balance sheet means that not all current liabilities are included in the calculation because they cannot be derived from the balance sheet. This applies, for example, to salary payments, insurance premiums or rental payments.
- Further more, the liquidity ratios do not provide absolute values, i.e. they do not indicate the exact maturity of receivables and liabilities. The values determined are average values that reflect a relative relationship between certain parameters.
Using SAP Central Finance
Because this is the case, it is essential for companies not to rely solely on the meaningfulness of the key liquidity figures, but to carry out comprehensive, period-related liquidity planning.
The basis for such planning is provided by harmonized real-time data, such as that provided by SAP Central Finance. With professional liquidity planning, companies can identify liquidity bottlenecks better and in good time and initiate countermeasures.
Learn more about liquidity planning.
KPI Dashboard with over 40 key figures
Professional liquidity planning also includes the use of other key financial figures that are directly or indirectly related to securing liquidity.
GAMBIT, for example, provides its customers with a catalog of more than 40 of the most important key figures from the profit, financial and asset situation with a KPI dashboard.
In addition to the key figures liquidity ratio 1 to 3, the KPI Dashboard contains, among others, key figures such as equity ratio, debt ratio, dynamic debt-equity ratio, debtor target or various key figures on turnover time.