Liquidity ratios: paying short-term debts

What liquidity measures

The IBR-IRE study on ratio analysis gives the clearest definition: liquidity is the company's potential to mobilise, within the required time, the cash resources allowing it to meet its short-term commitments: amounts payable within one year to banks, suppliers, social security, the tax authorities, staff, and the instalments of long-term loans falling due.

Two official ratios of the National Bank measure it, from the broadest to the strictest.

Broad liquidity

This is ratio no. 13 of the Central Balance Sheet Office, computed for every accounts format, without condition:

Broad liquidity = (3 + 40/41 + 50/53 + 54/58 + 490/1) ÷ (42/48 + 492/3)

In the numerator, everything that can become money within the year: stocks and contracts in progress (3), amounts receivable within one year (40/41), current investments (50/53), cash at bank and in hand (54/58) and deferred charges and accrued income (490/1). In the denominator, everything that must be paid within the year: amounts payable within one year (42/48) and accrued charges and deferred income (492/3).

The IBR-IRE notes that this ratio is based on the definition of net working capital from the bottom of the balance sheet: when net working capital is positive, the ratio is above 1, and its evolution reflects the same information. The guide on working capital develops this link.

Strict liquidity

This is ratio no. 14, also computed for every format:

Strict liquidity = (40/41 + 50/53 + 54/58) ÷ 42/48

Stocks and accruals disappear: a stock must first be sold, sometimes slowly, before it yields money. This ratio matters above all for companies that hold a lot of stock; for a service company, it joins the broad ratio.

The benchmark of 1, and the reading by sector

The threshold of 1 has a mechanical meaning: above it, current assets cover amounts payable within one year. It is the threshold the National Bank uses when it checks the financial capacity of companies bidding for its public contracts: broad liquidity above 1, next to solvency above 20% and positive equity.

Beyond that threshold, the right value depends on the trade. The IBR-IRE study illustrates the correct reading: it places the ratio of a pharmaceutical company against the three quartiles of its sector published by the Central Balance Sheet Office (in its example, a strict liquidity of 0.70 sat at the level of the sector median, itself at 0.7). A value below 1 is therefore not necessarily abnormal: it all depends on how the sector finances itself.

What moves liquidity: the delays

The broad and strict ratios only imperfectly explain the evolution of liquidity, writes the IBR-IRE: one has to look at the components of the working capital requirement, that is the speed at which stocks turn, customers pay and suppliers are paid. The National Bank publishes three ratios for this in the full format, and two of them in the abridged and micro formats when turnover is disclosed:

NBB ratio	Formula (full format)	Reading
Number of days of customer credit (no. 17)	(40 + 9150) ÷ (70 + 74 − 740 + 9146) × 365	Average collection delay
Number of days of supplier credit (no. 18)	44 ÷ (600/8 + 61 + 9145) × 365	Average payment delay
Turnover of stocks of raw materials and goods (no. 15)	60 ÷ (30/31 + 34 + 35 + 36)	Number of renewals per year

A customer delay that lengthens from one year to the next, or a supplier delay that stretches beyond customary terms, shows before cash itself deteriorates.

Months of cash

FinScan adds a more concrete reading, which is not an NBB ratio: how many months the cash (50/53 + 54/58) covers the expenses.

• If turnover is published: cash ÷ monthly expenses, expenses being estimated by turnover less the result and depreciation, divided by twelve.
• If the year is loss-making: cash ÷ monthly loss before depreciation, that is how long the company can continue at the same pace without new resources.

Under three months, FinScan flags a critical vigilance: the company is exposed to the slightest collection delay. This threshold is a FinScan choice, not a norm.

FinScan also shows cash divided by amounts payable within one year (50/53 + 54/58) ÷ 42/48. This "immediate liquidity ratio" is not computed by the NBB; it complements the strict ratio when receivables are doubtful.

What a balance sheet does not show

Liquidity is a snapshot at the closing date. Three things escape it:

• an unused credit line, which gives a margin invisible on the balance sheet;
• strong seasonality: a toy shop on 31 December has neither the cash nor the stock of a 30 June;
• the quality of receivables: a 40/41 receivable on a struggling customer is worth less than its amount. The notes of the full format detail the write-downs recorded.

This is why liquidity is read together with cash flow, which says whether the business rebuilds the cash, and with payment delays.