One man’s trash is another man’s treasure. It’s an age-old adage that holds true today. Something you might discard as rubbish could be worth something to somebody else. However, there are some caveats to this rule.
If you want to receive money for your discarded items instead of just throwing them away, you might run into some problems. What if that person who wants your trash lives halfway around the world? What if the cost of shipping the item to them is more expensive than the cost of the item itself? What if there is no system in place for you to list it and for them to find it? And what if you have to wait years before anyone considers buying your trash?
This hoarder’s dilemma can be answered using corporate finance concepts. Simply put, trash is not a liquid asset. Your trash might be someone else’s treasure, but because it’s extremely illiquid, it really is just trash (and you’re better off donating it to your local thrift store). This condition has nothing to do with your trash’s state of matter; learn more about liquidity in this article.
What is liquidity?
Liquidity is a measure of how quickly assets can be bought or sold without changing their prices.
Liquid assets vs. illiquid assets
Certain assets are more liquid than others. For example, cash is the standard for liquidity—it is considered the most liquid asset. Stocks and bonds are also considered highly liquid because they can usually be bought and sold relatively easily. Homes and other property, on the other hand, are considered illiquid because they are more difficult to sell quickly or liquidate for an appropriate price.
Market liquidity vs. accounting liquidity
We can think of liquidity in two different ways: market liquidity and accounting liquidity. Analysts use market liquidity to determine how easily assets can be bought and sold within a particular market. In a highly liquid market, assets can be sold quickly without a drop in price. In a market with low liquidity, the quick sale of assets comes with a price cut.
Regardless of the liquidity of its market, a company may use accounting liquidity in order to calculate its own liquidity ratio. We’ll define this ratio and explain how to find it below.
What is liquidity ratio?
Liquidity ratio is assets divided by liabilities. Companies use liquidity ratio in order to calculate their own accounting liquidity utilizing data from a balance sheet. In comparing their assets and liabilities, companies can gain insight into their financial health and where they stand in relation to other companies. There are three common ways to calculate this ratio: current ratio, acid-test ratio (or quick ratio), and cash ratio.
Current ratio formula
Current Ratio = Current Assets/Current Liabilities
Current ratio is all of a company’s current assets (assets that can be turned into cash within the span of one year) divided by its current liabilities (all money the company will owe within the span of one year). This ratio is easy to calculate and allows you to see a simple snapshot of a company’s financial status.
Acid-test ratio (quick ratio)
Acid-test ratio formula
Acid-Test Ratio = Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable /Current Liabilities
Acid-test ratio, or quick ratio, is calculated similarly to current ratio, however it excludes illiquid assets. You can find this ratio by adding a company’s cash and cash equivalents, its marketable securities or short-term investments (like stocks and bonds), and accounts receivable, then dividing the sum by the company’s current liabilities. An acid-test ratio can give you more insight into a company’s current financial situation and tell you how equipped it is to pay off its debts in a timely fashion.
Cash ratio formula
Cash and Cash Equivalents + Short-Term Investments/Current Liabilities
A company’s cash ratio is the sum of cash and cash equivalents divided by current liabilities. It gives you an idea of how the company would manage paying off debts in case of an emergency or situation in which it would need to use all of its cash and liquid assets ASAP.
What is a good liquidity ratio?
In general, if your liquidity ratio is greater than 1, you’re doing well. There is no gold standard for a healthy liquidity ratio as it varies from market to market. It would be unreasonable to expect a construction company’s liquidity ratio to be the same as a stock broker’s.
If a company’s ratio starts climbing to a number much greater than one, that is called liquidity glut. Too many assets and not enough spending has a negative effect on the market. However, if the ratio is less than one, it could spell bankruptcy for the company as it indicates a struggle to pay off debts. Let’s look at some examples in the tech industry.
Image courtesy of Nasdaq
We can find Facebook’s liquidity ratios based on the balance sheet above. Here’s what we know about Facebook’s books according to data from December 2018.
- Cash and cash equivalents = $10,019,000
- Short-term investments = $31,095,000
- Accounts receivable = $7,587,000
- Total current assets = $50,480,000
- Total current liabilities = $7,017,000
Let’s plug these numbers into the three liquidity ratio formulas to find Facebook’s current, acid-test, and cash ratios.
- Current ratio: $50,480,000/$7,017,000 = 7.19
- Acid-test ratio: ($10,019,000 + $31,095,000 + $7,587,000)/ $7,017,000 = 6.94
- Cash ratio: ($10,019,000 + $31,095,000)/$7,017,000 = 5.86
Based on these calculations, Facebook is doing extremely well. All of their ratios are well above one, and they will have no trouble paying off debts short or long term. In fact, Facebook has some liquidity glut and could stand to spend or invest some cash.
Image courtesy of Nasdaq
Here is another example of a company balance sheet we can use to find liquidity ratios. This time, we’ll use Groupon’s data from December 2018.
- Cash and cash equivalents = $841,021
- Short-term investments = $0
- Accounts receivable = $69,493
- Total current assets = $998,629
- Total current liabilities = $957,174
Let’s plug these numbers into the three liquidity ratio formulas to find Groupon’s current, acid-test, and cash ratios.
- Current ratio: $998,629/$957,174 = 1.04
- Acid-test ratio: ($841,021 + $0 + $69,493)/$957,174 = 0.95
- Cash ratio: ($841,021 + $0)/$957,174 = 0.87
Groupon’s current ratio is just above one, but when you take a look at the company’s acid-test and cash ratios, at 0.95 and 0.87 they both fall below one. This means that Groupon may have trouble paying off its debts in the coming year.
A solid understanding of liquidity makes life a gas
Liquidity boils down to the ability to turn assets into cash. We can measure it in various ratios to gain insight into a company’s stability, or compare industries by the liquidity of their assets. We can even apply it to our personal assets to figure out whether they are trash or treasure in the eye of the corporate economy.
Find your company’s liquidity ratio using accounting software.