One of the great aspirations of any entrepreneur who makes the decision to become financially independent in order to leave work in the office behind, is to be able to start his own company or business with which he can achieve a better economic position.
However, despite the multiple efforts made to achieve these wishes, it is well known that in Spain, nine out of ten SMEs (small and medium-sized companies) that are created fail before having reached the first five years of life . Unfortunately, this situation usually occurs due to the little preparation and research that many of these entrepreneurs do, remaining only with good wishes and intentions to grow their businesses.
Precisely, one of the most practical tools that exist within the financial sector to guarantee the survival of a company, and better still, its constant growth, is what is known as the liquidity ratio. Knowing this strategy can become almost mandatory for small and large companies, as it is an essential part of the financial structures of any commercial entity.
What is the liquidity ratio?
Also called as current ratio or current ratio, it is one of the liquidity indicators most used today to determine the financial capacity of a company, and thus generate conditions with which it can assume its obligations and commitments in the short term.
Thus, The objective of the liquidity ratios is to diagnose if a company has enough elements to generate cash; Or in other words, if it is capable of converting its assets into short-term liquidity, that is, immediate cash through which it can settle its possible debts.
Economic ratios
One of the most important components within the application of the liquidity ratio, These are the so-called economic ratios or financial ratios, which are obtained from the balance sheet and the profit and loss account of a company.
In this way, calculate the different ratios, economic and financial information is also obtained on the situation in which the company is, which allows us to know if it is in good condition or if it is going through a bad financial moment.
Likewise, these calculations also allow us to know the evolution experienced by the company, which can be both positive and negative. Economic ratios can be classified in the following cases.
- Profitability ratios: They refer to the economic or financial profitability to face expenses and debts. In other words, they measure the level of efficiency in the use of the company's assets, in relation to the management of its operations.
- Balance ratios: They can be divided into working funds, treasury and equilibrium ratio.
- Solvency ratios: They refer to financial stability, which translates into debt values and equity.
- Liquidity ratios: This measure tells us about the general liquidity of the company.
Each of these classifications has the function of providing a realistic statistic about the present and future situation of the company, and depending on whether it is on the right track or vice versa, measures are taken to continue for the same advance or otherwise, to redefine the economic strategy that managers must take to prevent a possible crisis within the company.
How can the liquidity ratio be calculated?
In order to calculate this economic indicator, different types of liquidity ratio. For example, the following cases can be mentioned:
The running ratio, the acid test, the defensive test ratio, the working capital ratio, and the accounts receivable liquidity ratios.
Next we are going to review the management and application of each of these methods to develop the liquidity ratio of a company:
The current reason: The current ratio indicates the proportion of those short-term debts that can be covered by the asset, that is, the goods whose conversion into money can be made within the period corresponding to the due date of the debt.
The way to calculate this indicator is by dividing current assets by current liabilities. As we have been observing, current assets are made up of elements such as: cash accounts, banks, easily negotiable securities (those that can be quickly sold), inventories, as well as accounts and bills receivable.
The formula to obtain the current ratio is the following:
- Current Ratio = Current Assets / Current Liabilities
- Current Ratio = 50.000 / 15.000 Current Ratio = 3.33
For example, to understand this formula, suppose that a company has 50,000 euros of current assets and on the other hand it has an amount of 15,000 euros of current liabilities. In this way, as indicated in the formula, the result of the operation is 3.33, which indicates that for every euro that the company owes, it has 3.33 euros to pay or support that debt within the short term.
In this way, from this ratio the main measure of liquidity that a business entity can count on is obtained, a widely used strategy that has worked very well to determine the liquidity index of a company, as well as its ability to pay. and disposition of cash to face any type of eventuality or contingency that suddenly arises.
The acid test: It is an indicator that, unlike the previous one, can be more rigorous in its application, since in this case, those accounts that cannot be carried out easily are discarded from the total current assets, which provides as a result one more measure. demanding of the ability to pay in the short term that a company can play. In short, this indicator allows us to have a more rigorous control regarding the ability to pay on the debts incurred.
The acid test can be calculated by subtracting inventories or inventories from Current Assets, and then dividing the result of that amount by current liabilities.
- Acid test = (Current Assets - Inventories) / Current Liabilities
Defensive Test Ratio:
This indicator refers to the ability of the company to carry out its operations with its most immediate liquid assets, thus avoiding having to resort to your sales flows to be able to assume your debts.
As a result, this type of ratio allows us to measure the financial capacity of the company to assume immediate debts without compromising those assets that do not have enough liquidity to use them as cash available in the payment of debts that are due to become due.
The assets that are taken into account when applying this type of ratio are: assets held in cash and marketable securities, through which the influence of time as a determining variable of certain transactions can be avoided, and with this, the uncertainty that can be generated by the prices of the other accounts of the current active.
To calculate this type of ratio, the total cash and bank balances are divided by current liabilities.
- Defensive test = Cash banks / current liabilities =%
Working capital ratio:
This ratio is obtained by subtracting current assets from current liabilities, and shows what a company can have after paying its immediate debts. In other words, it is an indicator that determines the amount of money that a company can have to operate on a daily basis, so it allows us to know what is left to continue operating after having paid off all its outstanding debts.
To obtain the working capital ratio, the following formula is applied:
- Working Capital = Current Assets - Current Liabilities
Liquidity ratios of accounts receivable:
Finally, we have one of the most important ratios to determine the liquidity of a company. The accounts receivable liquidity ratio consists of an indicator that allows us to know the average time in which the accounts that are not yet collected can be converted into cash.
In this very useful indicator because it helps us determine if certain assets are really liquid, this in relation to the time it may take for the outstanding accounts to be collected, that is, to the extent that they can be collected within a reasonable period of time.
In the end, knowing this liquidity ratio is vital so that more precise strategies can be developed when taking certain financial risks, around debts or credits that may affect the financial stability of a company in the short term.
- To calculate this liquidity ratio, the following formula is used:
- Average collection period = Account receivable x days in the year / annual credit sales = days
In consecuense
Throughout this article, we have been able to observe that the called Liquidity Ratio It is currently positioned as one of the best tools and strategies to maintain the financial strength of any business entity.
Naturally that to ensure your success, companies need to apply all kinds of administrative measures, but of all these, just as we have been able to verify, the liquidity ratio is essential if it is to maintain its economic stability, which translates into always having the necessary liquidity to solve payments, debts and all kinds of economic eventuality that may arise in the short term.