Essential Liquidity Ratios and Metrics
It’s vital for SaaS companies to understand how well they can meet their near-term financial responsibilities, and it is something both investors and lenders will be interested in. The two most commonly used liquidity metrics in financial accounting are the Current Ratio and Quick Ratio, which are described in more detail below. By utilizing liquidity ratios and metrics, businesses are able to make educated decisions regarding operations and better understand the impact each decision has on its liquidity.
Current Ratio
The Current Ratio is a financial measure that gives insight into the company’s ability to meet its short-term obligations – typically defined within a 12-month timeframe. To calculate the Current Ratio, the total sum of Current Assets is divided by Current Liabilities.
A higher Current Ratio indicates it is in a good position to meet its debt obligations and may indicate to potential lenders the business has the capacity to take on more debt. Similar to other metrics, tracking its changes over time can provide insights into the direction and sustainability of a business’s overall short-term cash flow.
Quick Ratio (Acid Test)
The Quick Ratio, not to be confused with the SaaS Quick Ratio, is similar to the Current Ratio in providing insight into its short-term obligations. However, the main difference between the two is that the Quick Ratio removes inventory and prepaid expenses from the current asset balance, which are current assets that can take a long time to convert into cash. The Quick Ratio formula is the sum of current assets, less inventory and prepaid expenses, divided by current liabilities.
A Quick Ratio of less than one may imply that there are inadequate accessible resources for meeting foreseen or unforeseen upcoming debts, which would require additional capital or alternative measures taken by the business to meet these obligations.
Cash Ratio
The Cash Ratio is similar to both the Current Ratio and the Quick Ratio; however, it only uses cash and cash equivalents in the formula rather than all or nearly all of a business’s current assets. The ratio indicates a company’s ability to service its short-term liabilities. The Cash Ratio formula is the sum of cash and cash equivalents, divided by the sum of all short-term liabilities.
A low Cash Ratio may indicate the company is carrying too much debt, or that excess cash is being carried in other current asset accounts, such as inventory or accounts receivable. In this situation, the business may not be able to generate enough cash to meet its debt servicing payments, which could result in insolvency. A higher Cash Ratio would indicate a business can meet its current liabilities; however, a too-high ratio can also indicate the business is not using its cash effectively.
Net Debt
Net Debt is a metric used to indicate the degree to which a company could pay off its debts in the event they were immediately due. This metric considers both current and long-term liabilities, whereas the three liquidity ratios reviewed above are only concerned with current liabilities. The Net Debt formula is the sum of current and long-term debt, less cash and cash equivalents.
A positive Net Debt metric means a business is carrying more debt than liquid assets and would have difficulty satisfying its debt obligations if they were made due immediately. An example where a debt or a loan is called immediately would be if the business didn’t meet a condition in the debt agreement, such as not taking on additional debt. On the other hand, a negative Net Debt metric indicates the business has sufficient liquid assets to satisfy its debt obligations if they were due immediately.
Frequently Asked Questions (FAQs)
What are the two 2 types of liquidity ratios?
Two common liquidity ratios are the Quick Ratio and the Current Ratio. These liquidity ratios give insight into a business’s ability to satisfy its current liabilities.
What are examples of the three types of liquidity ratios?
Three examples of liquidity ratios include the Cash Ratio, Quick Ratio, and Current Ratio. The main difference between the three ratios is the current assets used in the calculations. The Cash Ratio considers those current assets considered most liquid, such as cash and cash equivalents. The Current Ratio uses all current assets in its formula, while the Quick Ratio uses all current assets, less inventory.
What is the most commonly used liquidity ratios?
The most commonly used liquidity ratios are the Current Ratio and the Quick Ratio, also known as the Acid Test.
What is liquidity ratios meaning and types?
Liquidity ratios indicate the degree to which a business can use its current assets to service its short-term debt obligations. The most common liquidity ratios are the Current Ratio and the Quick Ratio, also known as the Acid Test.
Here are three more articles you may find useful:
Financial Leverage Ratios
G&A Expenses and Why They Matter for SaaS
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