One of the great aspirations of every entrepreneur who makes the decision to become financially independent 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 various efforts made to obtain these wishes, it is well known that in Spain nine out of ten SMEs (small and medium-sized companies) that are created fail before they have reached the first five years of life. Unfortunately, this situation usually happens due to the little preparation and research that many of these entrepreneurs do, remaining only with good wishes and intentions to grow their businesses.
Exactly, one of the most practical tools that exist within the financial sector to ensure the survival of a company, and better yet, its constant growth, is what is known as the liquidity ratio. Knowing this strategy can become almost mandatory for small and large companies, since it is an essential part of the financial structures of any commercial entity.
What is the liquidity index?
Also called as current reason or current reason, is one of the liquidity indicators most used today to establish the financial capacity of a company, and thus generate conditions with which it can take charge of its obligations and commitments in the short term.
Thus, The objective of liquidity ratios is to diagnose whether a company has enough items to generate cash; Or put another way, if you have the ability to convert your assets into short-term liquidity, in other words, immediate cash through which to pay off your possible debts.
Economic ratios
One of the most important components within the application of the liquidity index, 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 proportionsIn addition, economic and financial information is 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 categorized 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 connection with the management of its operations.
- Balance ratios: They can be divided into working funds, treasury and balance ratio.
- Solvency ratios: They refer to financial stability, which translates into debt and equity securities.
- Liquidity ratios: This measure informs us about the general liquidity of the company.
Each one 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 with the same progress or not, to redefine the economic strategy that managers must take to prevent a possible crisis within the company.
How can the liquidity ratio be calculated?
To calculate this economic indicator, different types of liquidity ratio. As an example, the following cases can be mentioned:
The execution rate, the litmus test, the defensive test rate, the working capital index, and the accounts receivable liquidity ratios.
Next, we are going to review the administration and application of each of these methods to develop the liquidity ratio of a company:
The current reason: The current reason indicates the proportion of those short-term debts that can be covered by the asset, in other words, the goods whose conversion into money can be carried out within the respective period 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 items such as: cash accounts, banks, easily negotiable securities (those that can be traded quickly), inventories, as well as accounts and bills of exchange.
The formula to get the current motive is the following:
- Current ratio = Current assets / Current liabilities
- Current Ratio = 50,000 / 15,000 Current Ratio = 3.33
As an example, to find out 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. From this dynamics, 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 in the short term.
From this dynamics, 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 establish the liquidity index of a company, as well as its payment capacity. and disposition of cash to face any type of eventuality or contingency that arises suddenly.
The acid test: It is an indicator that, unlike the previous one, can be more rigorous in its application, since in this circumstance, those accounts that cannot be carried out easily are discarded from the total current assets, which results in one more measure. demanding of the short-term payment capacity that a company can play. In short, this indicator enables us to have a more rigorous control over the ability to pay the debts incurred.
The litmus test can be calculated by subtracting inventories or inventories from Current Assets and subsequently dividing the result of that amount by current liabilities.
- Acid Test = (Current Assets - Inventories) / Current Liabilities
Defensive Test Ratio:
This indicator refers to the company's ability to carry out its operations with its most immediate liquid assets., thus avoiding having to resort to your sales flows to be able to take care of your debts.
As a consequence, this type of ratio enables us to measure the financial capacity of the company to take over 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.
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, and with it, the uncertainty that the prices of the other current asset accounts can generate can be avoided.
To calculate this type of ratio, total cash and bank balances are divided by current liabilities.
- Defensive test = Cash banks / current liabilities = %
Working capital ratio:
This link 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 enables us to know what is left to continue operating after having paid off all its outstanding debts.
To get the working capital coefficient, the following formula is applied:
- Working capital = Current assets - Current liabilities
Liquidity ratios of accounts receivable:
To finish, we have one of the most important ratios to establish the liquidity of a company. The accounts receivable liquidity index is an indicator that enables us to know the average time in which accounts that are not yet collected can be converted into cash.
It's about a very useful indicator because it helps us to establish if certain assets are truly liquid, This is related to the time it may take to collect the outstanding accounts, in other words, to the extent that they can be collected within a reasonable period of time.
At the end, knowing this liquidity ratio is vital so that more precise strategies can be developed when taking over certain financial risks, around debts or credits that may affect the financial stability of a company in the short term.
- To calculate this liquidity index, the following formula is used:
- Average collection period = Account receivable x days of the year / annual credit sales = days
as a result
Throughout this post, we have been able to observe that the called liquidity index At this time, it is 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, as we have been able to check, the liquidity ratio is essential to maintain its economic stability, which translates into always having the necessary liquidity to settle payments, debts and all kinds of economic eventualities that may arise in the short term.
