“When the tide goes out, you can see who was swimming naked” - Warren Buffett. With this phrase, the greatest investor of all time offers an important reflection for both life and investing. The lowering tide refers to the end of periods of economic growth or bull markets, while swimming naked means lacking protection. Essentially, the message is that when the economic boom ends, it becomes clear which companies were prepared to face the crisis and which were not.

Currently, according to many experts, we are in a period of recession. Only companies with a solid financial position will be able to weather the crisis. One of the most important conditions for strong finances is the ability to cover debts, which can be measured through liquidity ratios. In this Hapi article, we explain the key liquidity ratios to understand a company's liquidity and why they are particularly important during times of recession.

What Are Liquidity Ratios?

A liquidity ratio is a financial metric used to evaluate a company’s ability to cover its short-term debt, i.e., its capacity to pay off current liabilities with current assets.

The term “current” refers to a period of less than 12 months. A current asset is one that can be converted to cash within a year, including cash, marketable securities, accounts receivable, and inventory. Similarly, current liabilities are debts due within a year, such as bank overdrafts, trade payables, taxes payable, and wages payable.

From a practical standpoint, short-term debt can only be paid using the company’s current assets. Therefore, liquidity ratios are used to study a company's ability to cover its debt.

What Are the Main Liquidity Ratios?

Current Ratio

The Current Ratio is calculated by dividing current assets by current liabilities. If the ratio is greater than 1, the company can cover its short-term debt with its short-term assets. A company with a ratio of less than 1 lacks sufficient assets to meet short-term obligations, as it has a higher proportion of liabilities compared to the value of its current assets. An excessively high Current Ratio could indicate that the company is not managing its funds effectively.

Current Ratio = Current Assets / Current Liabilities

Quick Ratio or Acid Test

Also known as the Acid Test, this ratio measures a company’s ability to pay its short-term liabilities with assets that can easily be converted into cash, such as cash, stocks, bonds, and receivables. Unlike the Current Ratio, it excludes inventory, which can sometimes be difficult to liquidate quickly, making the Quick Ratio more conservative.

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Cash Ratio

The Cash Ratio considers only cash and divides it by current liabilities. This ratio is more stringent as it doesn’t account for other assets that could potentially be used to cover short-term debts. However, its advantage is that it acknowledges that inventory can take months to sell and receivables may take weeks to collect, whereas cash is always available to creditors.

Cash Ratio = Cash / Current Liabilities

To better understand these ratios, let’s look at Meta Platforms (Facebook)'s Balance Sheet:

You can find this in the company’s 10-K or 10-Q earnings reports, which are published annually and quarterly, respectively.

In this example, we see that by the end of 2021, Meta’s current assets were $66.6 billion, while its current liabilities were $21.1 billion. Additionally, cash stood at $16.6 billion. By performing the calculations:

Current Ratio = 66.6 / 21.1 = 3.15

Cash Ratio = 16.6 / 21.1 = 0.78

This shows that META had a healthy Current Ratio by the end of 2021.

Why Are Liquidity Ratios Important?

Banks and investors look at liquidity when deciding whether to lend or invest money in a business.

Liquidity ratios reveal a company’s availability of cash, which ultimately determines its short-term financial health. Higher ratios indicate financial stability, while lower ratios may signal financial difficulties.

Liquidity is especially crucial during a recession, as it indicates a business's resilience. Companies require more liquidity during an economic downturn because liquid assets provide greater flexibility. Quick access to cash gives a company the flexibility to pay off debts even when revenue generation is interrupted.

In summary, liquidity ratios are essential for determining a company's financial strength. These ratios—Current Ratio, Quick Ratio, and Cash Ratio—evaluate a company’s ability to cover short-term debts. By applying this knowledge, you can start making informed investments. Hapi is an app that allows you to invest in stocks and cryptocurrencies securely and instantly. All you need is a smartphone and a few minutes to begin your investment journey. Click here to start investing now!