# Total liquidity ratio. Calculation of total liquidity ratio

The insolvency of the company is often a sure sign of its future bankruptcy. Failure to pay in time for invoices issued by counterparties leads to lawsuits, which can be very difficult to pay in connection with the loss of commercial reputation. Therefore, for the successful functioning of the enterprise requires timely financial analysis. Its basis is the assessment of the company's solvency using a number of indicators. These, in particular, include the total liquidity ratio.

The calculation of this indicator makes it possible to understand whether the company in question is able to pay in time the arising claims of its creditors. The ratio of current assets to current liabilities is the total liquidity ratio, the formula of which is the subject of this article.

## Essence of the concept

To begin, let's understand what liquidity is. This economic term refers to the ability of one type of asset to convert to another or to be sold at a price close to the market. Money is the most liquid value, because it can be exchanged for almost anything. Fundamental to assess the solvency of the company represents the rate of conversion. The larger it is, the more liquid its assets are.

## Classification of balance sheet items

Experts identify three groups of values owned by companies: high, low and illiquid. At the same time, it should be understood that reckoning with the latter does not mean that this value cannot be sold in principle, but only that its price when sold on the market will be much lower than the nominal one. If it cannot be converted into its cash equivalent under any circumstances, then it cannot be counted as assets at all and put on the company's balance sheet, and even less so when the total liquidity ratio or any other solvency indicator is calculated.

## Main groups

We arrange the main items of the balance sheet in descending order of their ability to quickly convert into money:

- funds on current bank accounts and on hand;
- government securities and bank IOs;
- short-term receivables;
- corporate stocks and bills;
- equipment, facilities, buildings;
- unfinished construction objects.

The greater the number of highly liquid assets a company possesses, the easier it will be to pay off unexpected liabilities. It is the assessment of their quality and is engaged in financial analysis.

## Key indicators

There are three main indicators for assessing the solvency of the company - the absolute, fast and current liquidity ratios. The first is the share of the most convertible assets in the volume of current liabilities. Its normal value is a digit greater than 0.2. This means that a company can pay off 20% of its short-term debt through its most rapidly convertible assets. If this figure is less than 0.2, then this is a reason to think about increasing the cash in the bank account and balances on hand.

The quick (urgent) liquidity ratio is private of dividing current assets less inventories into short-term liabilities. The norm is from 0.8 to 1. A large number may indicate an irrational distribution of resources. The current (total) liquidity ratio is a measure of financial analysis, which is the ratio of current assets and current liabilities. Its normal value is in the range from 1.5 to 3.

## Total liquidity ratio: formula

For the purposes of calculation, we divide all assets and liabilities into groups. We denote the assets by the letters A1, A2, A3, A4, where the figure indicates the liquidity of the value under consideration. Similarly, we will combine in groups of liabilities. P1, P2, P3 and P4 are short, medium and long-term liabilities, as well as permanent ones. An enterprise is considered liquid if the assets of each group exceed the corresponding liabilities. The total liquidity ratio (K) will be equal to the ratio of the sum of all values, except for hard-to-implement, and short to medium-term liabilities, or K = (A1 + A2 + A3) / (P1 + P2). If we substitute in it the values from the financial statements, then we will be able to evaluate the solvency of the company.If we consider the formula in terms of accounting analysis, then the total liquidity ratio is the share of current assets (AA), excluding the debt on statutory contributions (ST) in the amount of short-term debt (CP). Thus, K = (OA - ZU) / KZ.

## The practical value of the indicator

The calculation of the total liquidity ratio allows you to understand whether the company is able to repay its short-term debt at the expense of current assets. A normal value is from 1.5 to 2.5. If the overall balance liquidity ratio calculated by the above method is less than 1, this means that the company can at any time declare its insolvency and stop paying its current accounts. The next stage can be bankruptcy, because it’s impossible to solve the problem so much that it’s running, without significant financial injections. If the value of the coefficient is more than 3, then this indicates that capital is used irrationally. To solve such a problem is very simple - you need to invest free funds in less liquid, but more profitable assets.

## Liquidity management

Effective management includes not only control over the work of employees, but also monitoring of existing property and obligations. There are two main ways to manage risks in the field of liquidity: control over the volume of assets and liabilities. Management in this area is based on the so-called GAP-analysis, which allows us to estimate the absolute and relative gap between the available and borrowed funds. It is aimed at maintaining a conditionally safe amount of assets that will allow you to respond to unexpected obligations to counterparties.

Similarly, any person lays an amount in case of unforeseen circumstances. Competent liquidity management allows the company not only to survive during the economic crisis, but also to buy resources more cheaply in the event of unexpected lucrative offers.

## Increase solvency

If the total liquidity ratio (coverage) is less than 0.8, then any crisis phenomenon can put the company on the verge of bankruptcy. There are several ways to prevent the implementation of such a sad scenario:

- Reduce accounts receivable.
- Increase the profitability of the enterprise.
- Increase the volume of own current assets and reduce the number of stocks.
- To issue securities for additional attraction of free cash resources.
- Reduce the amount of short-term liabilities.

Optimization of the structure of assets and liabilities is a rather complicated task that requires the preparation of a competent and well-considered scheme. If the owner of the enterprise does not understand this, then it is better to invite a highly qualified specialist. The cost of hiring it will pay off many times over in the future, since the right structure of own and borrowed funds is the basis for the prosperity of any commercial organization.