Liquidity ratios for investing

The liquidity ratios refer to the ability of the company to meet the payments of its short-term debts.

This is easier to understand if we see that not only companies but families also have their particular liquidity ratios because they also have short-term collection rights (normally salaries) and payment obligations (rent, mortgage, etc.).

That is why it is not surprising that many investors use them to support their long-term investment decisions.

These ratios are calculated in a fairly logical way that results from dividing the asset (our “collection rights”) between the liabilities (our “payment obligations”).

This would have to result in a positive number that would come to say that we have more money entering the short term of the one that will come out, in the same way that a family or individual would have to wait to collect more money than they will spend, because otherwise we would have a problem.

Well, the liquidity ratios would be the following: current ratio, acid test, defensive test, working capital ratio, liquidity ratio of accounts receivable.

Ratio of current ratio

This current ratio becomes the simplest and most basic of the liquidity ratios, which results from dividing current assets by current liabilities, that is, our short-term collection rights from our short-term payment obligations.

These collection rights would include bank accounts, cash and all types of easily liquidated securities, such as a package of stocks or inventories.

Current ratio = current asset / current liability

Here you can see a little the problem that these ratios have, especially when we enter a period of financial problems, and is that these “inventories” may have a price on the books but in the real market may have another very different, which sometimes makes these types of ratios very limited, as is obvious.

Here the thing is clear, the higher the ratio, above 1, the company’s better liquidity position and supposedly this should be more solvent in the short term. But beware, because an excessive liquidity ratio could also tell us that the company is misusing its resources leaving them in “inefficient productions”, when they could be dedicated.

The acid test

This ratio is more demanding than the previous one because it eliminates the least liquid accounts of the asset, which means that our ratio is already closer to 1 or could even lower this in some cases.

The result is the same as the previous one but subtracting the inventory from the current asset.

Acidity ratio = Current assets – inventories / current liabilities

As in the previous case, the greater is supposed to be better.

Ideally, it should be well above 1.

The subject of inventories is understood a little by what I said before; since they can vary in price a lot, for example imagine an inventory based on aluminium construction in the middle of a collapse of the real estate market. It is clear that this inventory would drop in price dramatically.

As always, a better way to see this ratio could be to see if it will be reduced over time which could give us signs that the company is getting too short-term debt to a point perhaps dangerous.

On the contrary, the ratio grows is that we will probably be facing a growth in sales and with an inventory with high turnover. Here the cash is entering the box in abundance.

Defensive test ratio

This ratio is based on the comparison of the most liquid assets of the balance sheet, such as cash and bank accounts with respect to current liabilities.

This is a ratio that we could almost call cash. That is to say, if the company has constant sound money to pay its expenses easily or not, or if on the contrary it has to wait to “sell”.

Defensive test ratio = Cash Banks / current liabilities

Average collection period ratio

With this ratio we intend to see if the company collects its debts in the short term in a reasonable time, because it is worthless that we have values ​​in a short balance when the average payment period approaches almost the long term.

Ratio average collection period = Accounts receivable * 360 days / annual sales on credit = days

With this ratio we see if we charge our suppliers fast or not, for example in 30 days on average, 50 or 180.

It is not the same as a company that charges 40 days on average than another company that charges 150. The first obviously has much more liquidity.

Rotation of accounts receivable

This would be a variation of the average collection ratio resulting in a ratio that tells us the number of times that short-term sales are made in each year.

Ratio of turnover of accounts receivable = Annual sales on credit / accounts receivable = times

Do the liquidity ratios work to invest?

Honestly, just by applying these ratios you will not discover any Holy Grail when it comes to beating the market or investing efficiently in a spectacular way.

It is clear that this is a fairly specific and limited ratio, but not for nothing, because we could obtain some interesting data from it, especially when comparing companies in the same sector, and adding other variables.

One of the most studied liquidity ratios is usually that of acidity, which is included in almost all the fundamental analysis packages that we can find out there.

Let’s see an example of these liquidity ratios in some companies in the oil sector.

Example of liquidity ratios to invest

In this case I will only take the acidity ratio on some of the most important companies in the world of the oil sector.

The companies will be the following: Exxon, Royal Dutch, Total, Repsol and Petrobras.

Acid test200920102011Variation2012 to june 2014 
Royal Dutch0.810.830.88+8.6%+10%

In the table I have included a supposed investment that we would have made at the beginning of 2012 in any of those actions and that we would have maintained for two and a half years until June 2014.

acid test invest
Petrobras: orange
Royal Dutch: candles
Repsol: purple
Exxon: red
Total: green

In the graph we can also see how those investments would have been maintained to this day.

In this case I have not included the dividends that should not be very different between companies of these characteristics and sector and less for a period of two and a half years of investment. The differences could be more important in a period of 5 to 10 years, but we should look at the issue.

What we see is quite curious.

If we take into account the data that go from 2009 to 2011, the company with the worst liquidity is Exxon, while the company with the best liquidity is Petrobras.

As for the variation in those three years, Petrobras is the one that most increases its acid test ratio, while Exxon and Repsol are the ones that worsen the most.

What would an investor do based on acidity in early 2012 if he had to invest in one of these companies?

Well, it could possibly conclude that the best company in terms of liquidity and solvency in the short term is Petrobras, both by acid test and improvement of it in those years.

The worst company would be Exxon, with a “deterioration” of its liquidity and a fairly low data.

What happened if this investor bought and kept a couple of long years?

Let’s imagine that we are in mid-2014 and that this investor would have a package of Petrobras shares.

Surely it would be pulling the hair because it would be losing 40% of its capital and other companies with worse behaviours in their analysis of 2012, such as Exxon or Total, would be earning a lot, 20 and 40%, respectively.

The difference between winning 40% and losing the same amount is very remarkable.

If you invest 10,000 and after two years you have 6,000, it is not the same as if you have 14,000 euros or dollars.

As you can see, and this was a randomly chosen example, this topic of liquidity ratios can be very misleading because in the end the theory is not fulfilled.

This topic of theory and practice is part of the stock market as something inseparable.

It is clear that what the theory says is not fulfilled in a very significant amount of times in the Stock Exchange.

So, why study these liquidity ratios?

What I can say is that it never hurts to know about these ratios and that even a good application of them along with other variables could give us some interesting result, at least in the medium term, but as we can see we cannot trust blindly to read a “Manual of fundamental analysis” and believe that with it we will be able to beat the market because input the technical postulates of fundamental analysis are not met in many cases, like the one we just saw.

Greetings and good trading