Critical Liquidity Ratio: Value

The effectiveness of the enterprise or organization, as well as their current state of affairs, is determined by solvency and liquidity. It is important to distinguish between these two concepts. Solvency of an enterprise means its ability to pay off its own debt. Liquidity means the sufficiency of funds available to the organization for settlement at the current moment. However, in the non-specialized literature these concepts are often used as synonyms. The critical liquidity ratio is an indicator of the short-term solvency of an enterprise. The more cash the organization has at its disposal, the better the prospect of the organization looks. In today's article, we will consider three main liquidity assessment ratios.

Term definition

In order to determine what the critical liquidity ratio means, it is important to first deal with the underlying concept. Moreover, it applies not only to enterprises, but also to banks and the market as a whole. The critical liquidity ratio is high when the organization can timely fulfill its obligations. The best values ​​are those that can be easily and quickly, and most importantly with minimal loss of money, to sell. Highly liquid is a market in which there is always a supply and demand of goods.

Assets and liabilities

The value of the critical liquidity ratio depends on the articles of the organization's balance sheet. Assets are resources that are at the disposal of the enterprise. They are divided into three large groups by liquidity level. These include cash, stocks and receivables. Liabilities represent liabilities of an entity. They are divided into two groups by maturity.

Categories of own resources and obligations

Assets can be divided into such categories according to their degree of liquidity:

1. A1 - money, bank bills, short-term stocks and bonds. This type of asset is ready for an immediate exchange for another.
2. A2 - accounts receivable. This group includes non-received funds for already sold products and unsold goods. They have less liquidity compared to the first group.
3. A3 - stocks. It is extremely difficult to quickly realize this category of assets and during such a conversion they may lose a significant part of their initial value.
4. A4 - difficult to sell means. This group includes receivables from bankrupt enterprises and other doubtful assets.

The four groups are divided and liabilities. Denote them by P1, P2, P3 and P4 in the order of the dates of their repayment. A company is considered liquid for which all four equalities are observed: A1> P1, A2> P2, A3> P3, A4

Liquidity ratios

There are three main factors that characterize the ability of an enterprise to respond timely to its obligations. Let's consider each of them in order. The absolute liquidity ratio compares the first group of assets with the corresponding category of liabilities. Its normative value is 0.2-0.5. The current liquidity indicator shows the degree to which short-term liabilities are covered by the first three groups of assets. Its norm is 2 or more.

Critical Liquidity Ratio: Formula

The solvency of the enterprise at any given time depends on the coverage of short-term liabilities with various types of personal values.The critical liquidity ratio demonstrates the ratio of the first group of liabilities and three categories of liabilities (except the fourth). He is closer than other indicators to determining the possibility of an early bankruptcy of an enterprise. The critical liquidity ratio shows how Short-term liabilities are covered by the most convertible working capital items. His formula is as follows: K = (A1 + A2) / P1.

Critical liquidity ratio: norm and practical value

This indicator reflects the possibility of a situation where the company can pay off its debt at this particular moment. Only stocks are not taken into account. This is due to the fact that they are a difficult asset. As a result of their emergency sale, they lose a significant part of their initial value. The critical liquidity ratio should have a value of about 0.7-0.8. This means that the first two groups of assets should cover 70-80% of short-term liabilities.

What determines the cost of resources at the disposal of the enterprise?

We found that the critical liquidity ratio shows the degree of coverage of short-term liabilities with cash and receivables. But does the ability to quickly and painlessly convert their value? Theory and practice show that investors expect large returns on assets with low liquidity. This is due to the fact that they understand the risk associated with the difficulties of selling them. The greater the liquidity of an asset, the higher its price and lower expected income from it.

Any enterprise is created for profit. But it cannot function separately. We have suppliers and buyers, lenders and borrowers. Therefore, there is a danger of an imbalance in the balance sheet. Such a situation with the wrong management policy can even lead to bankruptcy. Therefore, the critical liquidity ratio, the formula of which was considered above, is so important. Using it, you can assess the risk of bankruptcy of the organization. Solvency and liquidity are two main indicators of the financial solvency of an enterprise. In the non-specialized literature, they are often used as synonyms. Short-term solvency - this is liquidity. It is carried out using three coefficients. These include the indicator of current, critical and absolute liquidity.