Liquidity Ratios
Intuition
Liquidity ratios answer: can this company pay its bills in the short run? A company can be profitable on paper and still run out of cash if it can't convert assets into cash fast enough to meet immediate obligations.
The 2008 crisis and several high-profile Indian corporate failures (IL&FS in 2018, DHFL in 2019) demonstrated how companies that appeared profitable and even investment-grade rated could suffer rapid liquidity collapse when short-term funding dried up. Liquidity analysis is the first line of distress detection.
Liquidity is distinct from solvency, a company can be technically solvent (assets > liabilities) but still illiquid if its assets are long-dated and illiquid while liabilities are short-dated. This asset-liability mismatch is the core of most financial crises.
Mechanics
Three standard ratios:
Current Ratio = Current Assets ÷ Current Liabilities A ratio above 1.0 means current assets exceed current liabilities. General benchmark: 1.5–2.0× for manufacturing. However, context matters enormously, a retailer like DMart may run below 1.0× comfortably because of its negative working capital model.
Quick Ratio (Acid Test) = (Current Assets − Inventories) ÷ Current Liabilities More conservative, removes inventory because it may take time to sell. Benchmark: 1.0× or above.
Cash Ratio = (Cash + Cash Equivalents + Current Investments) ÷ Current Liabilities The most conservative. Shows how much immediate cash is available. Very low ratios are fine for stable businesses with committed credit lines; concerning for businesses facing refinancing risk.
Other liquidity signals:
- Interest Coverage (EBIT ÷ Interest Expense): Below 1.5× suggests stress
- Debt Service Coverage (DSCR = EBITDA ÷ (Interest + Principal Repayment)): Below 1.0× means the company cannot service debt from operations
- Cash burn rate (for pre-revenue companies): months of runway = Cash ÷ Monthly cash burn
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