Liquidity ratio: balance formula and normative value

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

One of the indicators of the company's activity is the level of liquidity. It assesses the creditworthiness of the organization, its ability to fully pay off its obligations on time. More details about what liquidity ratios exist, formulas for the new balance for calculating each indicator are presented in the article below.

Essence

Liquidity is the extent to which a firm's assets cover its liabilities. The latter are divided into groups depending on the period of conversion into cash. According to this indicator, it is estimated:

• firm's ability to respond quickly to financial problems;
• ability to increase assets with growing sales volumes;
• ability to repay debts.

Degrees of liquidity

Insufficient liquidity is expressed in the inability to pay debts and obligations. We have to sell fixed assets, and in the worst case, liquidate the organization. The deterioration of the financial situation is expressed in a decreaseprofitability, loss of capital investments of owners, delay in payment of interest and part of the principal on the loan.

The quick liquidity ratio (the formula for the balance sheet for calculation will be presented below) reflects the ability of an economic entity to repay the debt using the available funds in the accounts. Current solvency may affect the relationship with customers and suppliers. If an enterprise is unable to repay its debts on time, its continued existence is in doubt.

Any liquidity ratio (the formula for the balance sheet for calculation will be presented below) is determined by the ratio of the organization's assets and liabilities. These indicators are divided into four groups. In the same way, any liquidity ratio (the formula for calculating the balance sheet is needed for analyzing activities) can be determined separately for quickly and slowly sold assets and liabilities.

Assets

Liquidity is the ability of an enterprise's property to generate a certain income. The speed of this process just reflects the liquidity ratio. The balance formula for calculations will be presented below. The larger it is, the better the enterprise "stands on its feet."

Let's rank assets by the speed of their conversion into cash:

• money in accounts and at the box office;
• bills, treasury securities;
• non-overdue debt to suppliers, loans issued, the Central Bank of other enterprises;
• stocks;
• equipment;
• structures;
• WIP.

Now let's distribute the assets into groups:

A1 (the most liquid): funds in cash and in a bank account, shares of other enterprises

A2 (fast selling): short-term debt of counterparties

A3 (slow selling): stocks, WIP, long-term investments

A4 (hard to sell) - non-current assets

A specific asset belongs to one or another group depending on the degree of use. For example, for a machine-building plant, a lathe would be classified as "inventory", and a machine made specifically for the exhibition would be a non-current asset with a useful life of several years.

Liabilities

The liquidity ratio, the formula for the balance of which is presented below, is determined by the ratio of assets to liabilities. The latter are also divided into groups:

• P1 are the most requested commitments.
• P2 - loans valid up to 12 months.
• P3 - other long-term loans.
• P4 - enterprise reserves

The lines of each of the listed groups must match the degree of liquidity of the assets. Therefore, before making calculations, it is desirable to modernize the financial statements.

Balance liquidity

For further calculations, you need to compare the monetary values of the groups. In this case, the following ratios must be fulfilled:

• A1 > P1.
• A2 > P2.
• A3 > R3.
• A4 < P4.

If the first three of the listed conditions are met, then the fourth one will be fulfilled automatically. However, a shortage of funds in one of the asset groups cannot be compensated by an overabundance in the other, since fast-moving funds cannot replace slow-moving assets.

To conduct a comprehensive assessment, the overall liquidity ratio is calculated. Balance Formula:

L1=(A1 + (1/2)A 2 + (1/3)A3) / (P1 + (1/2)P2 + (1/3)P3).

The optimal value is 1 or more.

The information presented in this way is not full of details. A more detailed calculation of solvency is carried out by a group of indicators.

Current liquidity

The ability of a business entity to repay short-term liabilities at the expense of all assets shows the current liquidity ratio. Balance formula (line numbers):

Ktl=(1200 - 1230 - 1220) / (1500 - 1550 - 1530).

There is also another algorithm that can be used to calculate the current liquidity ratio. Balance Formula:

K=(OA - long-term DZ - debt of the founders) / (short liabilities)=(A1 + A2 + A3) / (Π1 + Π2).

The higher the value of the indicator, the better the solvency. Its normative values are calculated for each branch of production, but on average they fluctuate between 1.49-2.49. A value less than 0.99 indicates the inability of the enterprise to pay on time, andmore than 3 - about a high share of idle assets.

The coefficient reflects the solvency of the organization not only at the current moment, but also in emergency circumstances. However, it does not always provide the full picture. For trade enterprises, the value of the indicator is less than the normative one, while for production enterprises it is most often higher.

Term liquidity

The ability of a business entity to repay liabilities at the expense of marketable assets net of inventory reflects the quick liquidity ratio. Balance formula (line numbers):

Xl=(1230 + 1240 + 1250) / (1500 - 1550 - 1530).

Or:

K=(multiple DZ + multiple financial investments + DC) / (multiple loans)=(A1 + A2) / (Π1 + Π2).

In the calculation of this coefficient, as well as the previous one, reserves are not taken into account. From an economic point of view, the sale of this group of assets will bring the company the most losses.

The optimal value is 1.5, the minimum is 0.8. This indicator reflects the share of liabilities that can be covered by cash receipts from current activities. To increase the value of this indicator, it is necessary to increase the volume of own funds and attract long-term loans.

As in the previous case, a value of more than 3 indicates an irrationally organized capital structure, which is caused by slow inventory turnover and an increase in receivables.

Absolute liquidity

Subject Abilitymanagement to repay the debt at the expense of cash reflects the ratio of absolute liquidity. Balance formula (line numbers):

Cal=(240 + 250) / (500 – 550 – 530).

The optimal value is more than 0.2, the minimum is 0.1. It shows that the organization can pay off 20% of urgent obligations immediately. Despite the purely theoretical possibility of a need for urgent repayment of all loans, it is necessary to be able to calculate and analyze the absolute liquidity ratio. Balance Formula:

K=(short investment + DC) / (short loans)=A1 / (Π1 + Π2).

The calculation also uses the critical liquidity ratio. Balance Formula:

Kkl=(A1 + A2) / (P1 + P2).

Other indicators

Capital maneuverability: A3 / (AO - A4) - (P1 + P2).

Its decrease in dynamics is seen as a positive factor, since part of the funds frozen in inventories and receivables is released.

Share of assets in the balance sheet: (balance total - A4) / balance total.

Security with own funds: (P4 - A4) / (AO - A4).

The organization must have at least 10% own sources of funding in the capital structure.

Net working capital

This indicator reflects the difference between current assets and loans, accounts payable. This is the part of the capital that is formed by long-term loans andown funds. The formula for calculating is:

Net worth=OA - short-term loans=line 1200 - line 1500

Excess of working capital over liabilities indicates that the company is able to pay off debts, has reserves for expanding activities. The standard value is greater than zero. The lack of working capital indicates the inability of the organization to repay its obligations, and a significant excess indicates the irrational use of funds.

Example

On the balance sheet of the enterprise are:

• Cash (CF) – RUB 60,000
• Short-term investments (KFV) – 27,000 rubles
• Accounts receivable (RD) - 120,000 rubles
• OS - 265 thousand rubles.
• Intangible assets - 34 thousand rubles.
• Reserves (PZ) – RUB 158,000
• Long-term loans (KZ) – RUB 105,000
• Short-term loan (CC) - 94,000 rubles.
• Long-term loans - 180 thousand rubles.

Need to calculate the absolute liquidity ratio. Calculation formula:

Kal=(60 + 27) / (105 + 94)=0, 4372.

The optimal value is more than 0.2. The company is able to pay 43% of its obligations from the funds in the bank account.

Calculate the quick liquidity ratio. Balance Formula:

Xl=(50 + 27 + 120) / (105 + 94)=1, 09.

The minimum value of the indicator is 0.80. If the company uses all available funds, including the debt of debtors, then this amount will be 1.09 times more than the existing liabilities.

Calculate the coefficient of the criticalliquidity. Balance Formula:

Kcl=(50 + 27 + 120 + 158) / (105 + 94)=1, 628.

Interpretation of results

In themselves, the coefficients do not carry a semantic load, but in the context of time intervals, they characterize the activity of the enterprise in detail. Especially if they are supplemented by other calculated indicators and a more detailed consideration of the assets that are taken into account in a particular line of the balance sheet.

Illiquid inventory cannot be quickly sold or used in production. They should not be taken into account when calculating current liquidity.

In an organization that is part of a holding group, when calculating the liquidity ratio, indicators of internal receivables and payables are not taken into account. The level of solvency is best determined according to the absolute liquidity ratio.

Many problems will cause an overvaluation of assets. The inclusion of an unlikely debt collection in the calculations leads to an incorrect (reduced) assessment of solvency, obtaining unreliable data on the financial position of the organization.

On the other hand, with the exclusion from the calculation of assets, the probability of receiving income from which is low, it is difficult to achieve the normative values of liquidity indicators.