### Core Financial Modeling

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Learn moreA Liquidity Ratio measures a company’s ability to cover its short-term obligations using its “most liquid” assets (i.e., the assets that are easiest to turn into cash quickly). There are several types of liquidity ratios, and each includes different components of a company’s assets and liabilities.

**Liquidity Ratios Definition**: A Liquidity Ratio measures a company’s ability to cover its short-term obligations using its “most liquid” assets (i.e., the assets that are easiest to turn into cash quickly). There are several types of liquidity ratios, and each includes different components of a company’s assets and liabilities.

In corporate finance, people often focus on a company’s growth rates, profit margins, and valuation – but **liquidity ratios** can also be extremely useful in certain contexts, especially when you analyze a company from the perspective of lenders and suppliers.

Effectively, **liquidity ratios** indicate the company’s ability to pay off its short-term obligations as they come due, and they give you insight into how much “downside risk” the company has.

For example, if the economy enters a recession, and the company’s Cash balance starts declining, or it has trouble collecting Cash from customers, how much trouble is it in?

Could it still meet its obligations for a year? Or would have it to raise additional capital or sell assets to survive over the next year?

Since lenders and other debt investors focus very heavily on the **downside case**, liquidity ratios are critical for them – even if the average investment banker or valuation specialist doesn’t spend much time on them.

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Learn moreLiquidity Ratios – Slides (PDF)

Liquidity Ratios – Extracts from Illinois Tool Works Filings (PDF)

Illinois Tool Works – Liquidity Ratio Analysis (XL)

**1:39:** Part 1: The Top 3 “OG” Liquidity Ratios

**4:00:** Part 2: Unofficial Liquidity Ratios

**8:25:** Part 3: Liquidity Ratios in Real Life for Illinois Tool Works

**10:44:** Recap and Summary

The three most common liquidity ratios include:

**1) Current Ratio:** This assesses a company’s ability to pay off its short-term liabilities with *all* its current assets, including Inventory, which may be more difficult to convert into Cash quickly. The formula is:

**Current Ratio** = Current Assets / Current Liabilities

Here’s an example calculation for Illinois Tool Works [ITW]:

**2) Quick Ratio:** Measures a company’s ability to meet its short-term obligations using **only its most-liquid assets: **Cash & Cash-Equivalents and Accounts Receivable. The formula is:

**Quick Ratio** = (Cash & Cash-Equivalents + Accounts Receivable) / Current Liabilities

And here’s the calculation for the same company:

**3) Cash Ratio:** A stricter liquidity ratio that compares only Cash and Cash-Equivalents to the company’s obligations. The formula is:

**Cash Ratio **= (Cash + Cash-Equivalents) / Current Liabilities

And here’s the calculation:

In addition to the main three liquidity ratios above, there are some “unofficial” ratios that relate to the company’s capital intensity and operational and credit risk.

Here are a few examples:

**1) Working Capital / Revenue:** “Working Capital” refers to how much Cash the company has “tied up” in items necessary for its day-to-day operations, such as Inventory and Accounts Receivable, and it subtracts the operational items that the company *owes* to other parties, such as Accounts Payable and Accrued Expenses.

Working Capital / Revenue does not directly measure liquidity, but it does tell you *how important* these day-to-day assets and liabilities are for a company’s operations.

Companies with higher Working Capital / Revenue ratios are often perceived to be riskier and “less efficient” because as these companies generate cash flow, they keep more of it tied up in these accounts.

**2) Change in Working Capital / Change in Revenue: **This ratio tells you how much the company needs to *re-invest* in its operations to fund its growth. We have a full tutorial on the Change in Working Capital and what it means in valuations and financial models.

Similar to the Working Capital / Revenue ratio, a higher number here is often interpreted as indicating higher risk and lower efficiency.

The classic example is a **retailer**, such as Walmart or Costco: They tend to have high numbers here because they need to purchase Inventory in advance before they can sell their products to customers. Therefore, they need to *spend money* before they can *collect money*, which is less ideal than collecting money upfront.

This one is more of an *indirect* liquidity ratio since it measures the short-term/operating capital required for growth.

**3) Net Debt:** This metric represents the amount of debt a company would have if it used its available cash to pay down its outstanding debt. It’s calculated as Total Debt – Cash.

By itself, Net Debt doesn’t mean much because larger companies tend to have higher Debt and Cash balances due to their size.

So, you normally compare Net Debt to the company’s Total Capital or Net Capital (see below) or to metrics such as EBITDA to evaluate how well a company can repay this Debt eventually.

**4) Debt / Total Capital:** This measures the proportion of a company’s financing that comes from Debt. It measures **credit risk** because the higher the Debt percentage, the higher the company’s chances of default or bankruptcy. The formula is:

**Debt / Total Capital** = Total Debt / (Total Debt + Equity on Balance Sheet)

Note that you use the **Balance Sheet version of Equity**, AKA the Book Value – *not* the Market Cap or Equity Value.

You also add Preferred Stock in the denominator if the company has it; Lease Liabilities may also be included, especially in countries that use IFRS rather than U.S. GAAP and therefore, follow different lease accounting rules.

**5) Net Debt / Net Capital:** This ratio is the same as the one above, but it subtracts Cash in the numerator and denominator to get a better view of the company’s obligations *after* it repays the most Debt it possibly can.

The formula is:

**Net Debt / Net Capital** = (Total Debt – Cash) / (Total Debt + Equity on Balance Sheet – Cash)

If we consider both the “official” and “unofficial” liquidity ratios, here’s a quick summary:

**1) Current Ratio:** The Current Ratio is the **broadest** measure of liquidity since it considers all current assets, including Inventory, which might not be easy to convert into Cash. It gives you a general picture of the company’s short-term financial health, but might not represent true liquidity if the company’s assets are not easy to convert into Cash.

**2) Quick Ratio:** A more stringent measure of liquidity, the Quick Ratio assesses a company’s ability to pay off its current liabilities using its most-liquid assets (Cash & Cash-Equivalents and Accounts Receivable). It’s often viewed as a better reflection of true liquidity, especially for firms with slow or unpredictable Inventory turnover (e.g., spirits companies, which might hold Inventory for years or decades).

**3) Cash Ratio:** This is the **strictest** liquidity ratio because it incudes only Cash & Cash-Equivalents; it tells you whether a company can immediately settle its current liabilities without relying on asset sales, additional borrowing/fundraising, or the collection of owed customer payments.

**4) Working Capital / Revenue:** This ratio highlights the relationship between a company’s operational capital (working capital) and its sales. A higher ratio could suggest that a company requires more capital to generate sales, which might indicate a greater need to borrow or raise outside funding.

**5) Change in Working Capital / Change in Revenue:** This ratio tells you how much the company needs to *re-invest* in its operations to grow its net sales. It’s particularly useful for businesses in growth phases or undergoing significant operational shifts, and it is often used as a driver in financial models, such as the DCF, to project a company’s Free Cash Flow.

**6) Net Debt, Debt / Total Capital, and Net Debt / Net Capital:** While these aren’t pure liquidity ratios, they are important in understanding a company’s financial structure, leverage, and overall risk. For instance, high Net Debt might indicate some **refinancing risk** for the company when its Debt matures and needs to be repaid.

Financial models, such as 3-statement models and discounted cash flow analyses, typically use liquidity ratios as follows:

**1) Credit Models:** Lenders and credit analysts use these ratios to evaluate a company’s creditworthiness. Lenders can determine the risk associated with extending credit or approving a loan by understanding how easily a firm can cover its short-term obligations without needing to borrow more. This can influence debt vs. equity fundraising decisions as well.

**2) Scenario Analysis:** Liquidity ratios are used in scenario analyses where various financial situations are modeled to understand the potential outcomes. For instance, in a downturn, how would a company’s liquidity be affected if its Accounts Receivable collection were delayed? Or, what would happen if suppliers demanded higher upfront payment for Inventory purchases?

**3) Valuations:** While liquidity ratios focus on short-term financial health, they can also influence company valuations. A company with strong liquidity may be seen as less risky, possibly leading to a higher valuation. Conversely, poor liquidity can signal operational inefficiencies or impending financial distress, which could reduce a company’s valuation multiples.

**4) Cash Flow Risk Assessment:** Investors and stakeholders use liquidity ratios to assess cash flow risks. A firm with strong liquidity is less likely to face cash crunches, ensuring smooth operations even in unforeseen circumstances (e.g., a recession, market panic, energy crisis, pandemic, etc.).

To put together all the concepts above, we can calculate these ratios for Illinois Tool Works [ITW] over 3 years of its operations:

You can find all these numbers by going to the company’s Investor Relations site and reviewing its 10-K (annual report).

You can then paste the historical data into Excel and calculate the metrics for each year based on the formulas above:

The liquidity ratios here tell you that **the company’s overall liquidity has declined significantly** since the Current Ratio, Quick Ratio, and Cash Ratio have all fallen over these 3 years.

The main drivers seem to be the company’s falling Cash balance and rising Current Liabilities, mostly due to a rising Short-Term Debt balance:

Lenders and financial analysts would interpret these numbers as a negative sign since the company seems to have borrowed while letting its Cash decline; the other components of Current Assets and Current Liabilities are relatively stable.

The company is also fairly capital-intensive, since Working Capital represents 15-20% of revenue, and it needs to spend significant money on assets such as Inventory to grow since the Change in Working Capital / Change in Revenue numbers are all negative.

On the other hand, the company’s **long-term funding** situation appears stable because Debt / Total Capital and Net Debt / Net Capital stay in the same range over time.

So, the short answer here would be: “There are some concerning signs in the short term, but the company’s long-term financial picture seems fine.”

To reach more detailed conclusions, we’d have to dig into the company’s financial statements to see *why* Cash has declined so much over this period.

It would also be helpful to go back 10-15 years and evaluate these ratios over that longer period.

The liquidity ratios for many companies fluctuate significantly in short periods, even if they remain stable over the long term.

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.