How to use liquidity ratios when buying stocks

When buying stocks or other investments such as company bonds you want to obtain data that allows you to make an informed investment decision. Liquidity ratios are one category of information that should be considered as part of your fundamental analysis.

Liquidity ratios measure the ability of a company to meet its short-­term obligations (debt due within one year). They show the investor how many times the company short­-term liabilities are covered by their most liquid assets such as cash and cash equivalents (depending on the analyst, the liquid asset classes that are taken into account for the calculation can differ). A ratio of 1 indicates that the company is able to fully cover its short­-term liabilities, while a ratio lower than one is a red flag that might indicate the company is facing financial difficulty and may be at higher risk of bankruptcy. The higher the liquidity ratios the more likely the company will be able to pay its short-­term debt obligations. When using liquidity ratios to compare companies’ financial health, make sure you also compare the values against companies operating within the same industry and review several years to determine trends.

Common liquidity ratios include the current ratio, the quick ratio and the cash ratio which differ in the type of assets used when calculating the ratio.

The current ratio is calculated by dividing the Current Assets by the Current Liabilities

Current Ratio = Current Assets / Current Liabilities

The higher the ratio, the greater the amount of current assets the company will have that can be converted to cash to cover the short-­term obligations. If this ratio is less than 1 it is a red flag as it means the company has more current liabilities than current assets that can be converted into cash to cover them when due. A current ratio of 1.5 ­- 2 usually indicates a good safety margin. If the current ratio is too high it might also indicate that too much capital is tied up in the current assets (for example too much inventory or credit given to customers).

The quick ratio, which is also known as the acid­-test ratio, is more conservative than the current ratio as it only considers the more liquid assets (for example it does not include inventory).

Quick Ratio = (Cash and cash equivalents + Short­term investments + Accounts receivable) / Current Liabilities

A company with a quick ratio of 1 is considered to have a good level of liquidity.

The cash ratio, which is the most conservative of the three ratios is it only considers the assets which are already liquid, is calculated by dividing the Cash and cash equivalents by the Current liabilities.

Cash Ratio = Cash and cash equivalents / Current liabilities

Using liquidity ratios in combination with other financial ratios such as leverage ratios, profitability ratios and efficiency ratios will help you get a better idea of the overall financial position of a company and make an informed decision on whether it is a potential good investment opportunity.

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