What is liquidity?
An individual company’s liquidity refers to the business’ ability to pay off any debts that are held as they become due. Debts (in the form of corporate bonds) are not usually homogenous. A company might have a bond payable in 2 months’ time, or in 10 years. Liquidity normally refers to the ability of the company to pay off its ‘due and payable’ debts, rather than the total value of its debt load.
This is obviously a very important consideration for any investor, as there is only one consequence when a company cannot meet its obligations as a debtor – bankruptcy.
What do we mean by ‘liquid asset’?
The liquidity of an asset refers to how readily it can be converted to cash at a price consistent with its value.
ASX shares are normally considered to be highly liquid because they can be bought and sold in seconds. In contrast, a property is considered a rather illiquid asset because of the cost and time it takes to sell a property on the market.
If there is a consistent supply of willing buyers and sellers in a market, it is a fair indicator that an asset can be considered ‘liquid’.
All ASX shares are technically liquid, but some are more liquid than others. An ASX blue chip share like Commonwealth Bank of Australia (ASX: CBA) has a large market capitalisation, a relatively large supply of shares outstanding and typically attracts a large volume of share transactions during a typical trading day. Because of all these factors, CBA shares can be considered highly liquid.
In contrast, an ASX company with a small market capitalisation, such as shares outside the S&P/ASX 200 Index (ASX: XJO) or the All Ordinaries Index (ASX: XAO), will usually offer far less liquidity for investors.
That’s because there are fewer investors trading a smaller volume of shares on an average trading day. As such, investors might not find it easy to buy or sell these shares efficiently at a consistent market price. They may also find that a large buy or sell order can significantly move the share price in a lopsided manner.
Because of these factors, small-cap ASX shares are often described as more ‘illiquid’ by comparison.
When measuring a company’s liquidity, there are conventionally 2 methods: the current ratio and the quick ratio.
The current ratio is a metric that measures a company’s ability to pay off its current debts or liabilities (normally those payable within one year) with all of its current assets – liquid or illiquid. These might include assets such as cash, credit owed by other parties, or product inventories.
Whilst this method is the most comprehensive in its nature, it also throws up some problems. Whilst a company may technically have an ‘asset’ that can theoretically offset a debt, assets like inventories maynot practically be able to be converted to cash in order to pay off a company’s debts. As such, a company’s current ratio is best analysed in conjunction with a company’s quick ratio.
How to calculate the current ratio
The current ratio can be calculated with a simple formula:
Normally, a current ratio above 1 is considered ‘good’ as it indicates a company has more assets than liabilities on its balance sheet. Conversely, if a company has a current ratio below 1, it indicates that the company’s liabilities or debt obligations are worth more than the company’s assets, which is an ‘orange flag’ to say the least.
The quick ratio (also known as the ‘acid test ratio’) is similar in concept to the current ratio, but excludes those assets that don’t have sufficient liquidity of their own in the service of a company’s obligations, such as inventories.
These assets might technically bolster a company’s balance sheet on paper, but in practice they are relatively impotent in their ability to help a company meet its short-term debt obligations. In this way, the quick ratio is a more conservative metric for company evaluation than the current ratio.
How to calculate the quick ratio
There are a number of formulas that are conventionally used to calculate the quick ratio of a company. Here are a few:
As with the current ratio, a quick ratio of 1 is a good place to start assessing between a ‘good’ quick ratio (more assets than liabilities) and a ‘bad’ quick ratio (liabilities or debt obligations are higher than the company’s assets).
How should we use liquidity ratios?
On their own, the quick ratio or the current ratio are not silver bullet solutions to assessing companies and should be used in conjunction with other metrics and analysis. Either ratio on its own may not give an investor a complete picture of the health of a company. It may ignore a concerning debt load that might not be due and payable in the near term. It may also unnecessarily ring alarm bells over shareholder-friendly activities, such as the payment of a special dividend.
Using the quick and the current ratios during the evaluation of a current or potential investment is a great exercise. But it is where the story should start, not conclude.