Weve written several articles about the importance of regular financial benchmarking (both internal and external) for the health of a business. Of all the financial benchmark ratios a business owner could use to measure the financial health of their business, liquidity ratios may be the most important.
Why are liquidity ratios so important?
First, they represent assets that a company needs to operate on. Liquidity ratios are used to measure a company’s ability to meet current obligations as they come due. There are three that matter the most to a business owner and lender:
The current ratio indicates the extent to which current assets are available to satisfy current liabilities. Current ratios are usually stated in terms of absolute values (i.e., 2.5 to 1.0 or simply 2.5). A current ratio of less than 1 means there are greater current liabilities than there are current assets to pay them.
Formula: Current assets / current liabilities
However, it's important to keep in mind that some current assets are less liquid than others. That's where the quick ratio can shed some light.
The quick ratio indicates the extent to which the more liquid assets are available to satisfy current liabilities. Quick ratios are stated in terms of absolute values.The higher the quick ratio, the more cash a business has to pay its obligations and maintain safety cash. A quick ratio of 1.0 generally is considered a liquid position.
Formula: (Cash and cash equivalents short term investments net trade receivables) / current liabilities
Days of cash indicates the number of days revenue in cash. It is measured in a whole number indicating the number of days of cash a business has to operate given its current revenue rate. Generally 7-10 days is considered adequate, but more is preferred in times of fluctuating sales.
Formula: (Cash and cash equivalents) * 360 / revenue
This benchmark is an excellent planning tool for businesses. A business should maintain a certain level of safety cash in addition to the cash it needs to operate daily. Seasonal businesses need more days of cash going into a peak season then they do coming out of one. Cyclical businesses should also pay close attention to the days of cash benchmark and plan for up and down ticks in revenues.
If you'd like to know more about how your liquidity ratios and other financial data stack up to those of other companies in your industry, reach out to talk to one of our officers. We're happy to talk to you about how you can use this comparison data for strategic planning and help you set liquidity goals for your business.