The Business Guide to Liquidity Ratios

Liquidity management is especially important for companies looking to take on debt. And with debt financing becoming an increasingly attractive option in the current funding environment, understanding liquidity ratios needs to be a core component of the financial planning and cash flow analysis process.

And while liquidity snapshots can be useful, finance teams also need to ensure they have the capabilities to build this analysis into their financial model. That way, they can assess how strategic decisions could impact their liquidity position in the future.

There are a number of different liquidity ratios that can be useful in guiding this analysis. In this article, we’re going to explain the most widely used liquidity ratios, and illustrate how they should fit into a finance team’s operations.

What is Liquidity Ratio?

A liquidity ratio is a financial metric that helps a company evaluate its ability to cover short-term obligations using its liquid assets.

These metrics help assess a company’s financial health based on its ability to meet immediate financial demands.

The Importance of Liquidity Ratios

Liquidity ratios provide valuable insights into a company’s short-term financial health. While long term planning is important, a company can only fulfill its potential if it remains strong in the short term.

Here’s why liquidity ratios matter:

Risk Assessment

Liquidity ratios can sometimes act as a proxy for risk. A company with dwindling cash reserves has a higher risk of failure, while a large cash buffer can protect a company from volatility in their sales or in the economy.

For SaaS companies, specific liquidity ratios assess whether the company is managing to grow it’s recurring revenue.

For companies looking to fund expansion via debt, prospective lenders use liquidity ratios as one measure to assess the risk of that loan. Higher liquidity ratios imply a lower risk of default, making it easier for businesses to secure loans or negotiate better credit terms.

For equity financing, investors consider liquidity ratios to gauge a company’s stability and its ability to weather financial challenges, influencing investment decisions.

Management Efficiency

Liquidity ratios can offer an insight into the effectiveness of a company’s leadership.

From an operational standpoint, these ratios help identify inefficiencies in managing working capital. For example, a low liquidity ratio may indicate that a business is struggling to collect receivables or maintain appropriate inventory levels.

Liquidity ratios can also shed light on the effectiveness of the finance and treasury function. Maintaining healthy liquidity ratios requires financial efficiency, balancing annual budgets with unplanned expenditure, fluctuating revenue, tax obligations and financing costs.

Strategic Decision Making

Strategic decision making must involve analysis of how directives will impact liquidity. By incorporating liquidity ratios into financial models, businesses can predict how strategic decisions (such as geographic expansion or new product lines) will impact their future liquidity position.

Even for companies not looking to make major strategic moves, forecasting and managing liquidity ratios helps balance revenue and expenses to achieve sustainable long term growth.

Types of Liquidity Ratios

There isn’t one single liquidity ratio that’s right for every type of business. There are three main liquidity ratios, each with slightly different formulas. It’s important for a finance team to decide how they plan to use these ratios in their analysis, to ensure consistency in financial projections and reporting.

Traditional liquidity ratios consider ‘current’ assets and liabilities.These are assets that are liquid (i.e. cash) or expected to become liquid within the current fiscal year (e.g. inventory). Current liabilities are debts expected to be paid within the current year.

Current Ratio

The current ratio is a measure of a company’s ability to pay its short-term liabilities using all of its current assets. It’s calculated as:

• Current Ratio = Current Assets/Current Liabilities

​A higher current ratio suggests that a business can easily cover its short-term obligations. A ratio of 1 or above generally indicates good liquidity, as this suggests it could clear all current obligations with cash to spare. However, benchmarks do vary by industry.

SaaS Quick Ratio

The traditional quick ratio, also known as the acid-test ratio, excludes inventory and other less liquid assets to provide a clearer picture of a company’s ability to meet immediate liabilities.

Because SaaS companies typically don’t hold inventory, there’s a specific quick ratio known as the SaaS Quick Ratio which is generally used instead to assess cash inflow and outflow.

The SaaS Quick Ratio compares revenue inflows with revenue outflows to provide insight into the company’s growth efficiency. The formula looks like this:

• SaaS Quick Ratio = (New MRR + Expansion MRR)/(Downgrade MRR + Churn MRR)

This formula can easily exchange MRR for ARR if that’s a more relevant metric for your SaaS business. The overall objective is the same regardless.

The SaaS Quick Ratio essentially shows whether your recurring revenue is net positive or net negative. A ratio below 1 means your customers are churning faster than you’re adding new ones. That’s obviously very bad news.

Between 1 and 4 means you’re growing, but you could be doing it more efficiently. Above 4 is where you want to be. That means you’re adding $4 of new revenue for every $1 that’s churning out.

Cash Ratio

The cash ratio is the most conservative liquidity measure. It considers only the most liquid assets (cash and cash equivalents) against current liabilities. It’s calculated as:

• Cash Ratio = Cash and Cash Equivalents/Current Liabilities

Given that SaaS companies generally don’t hold inventory, the Cash Ratio should produce a very similar figure to the current ratio.

The Role of Liquidity Ratios in Funding and Valuation

Liquidity ratios are a key metric considered by both potential lenders and potential investors. Not only are they closely assessed in isolation, but strong liquidity ratios factor into overall company valuations as well. This can make both debt and equity financing easier to secure.

Evaluating Company Valuation

Liquidity ratios will generally influence a company’s valuation. They provide an indication of short-term financial health and stability, offering insights into how well a company can handle economic downturns or sudden revenue drops. This information is directly incorporated into valuation models.

High liquidity ratios often reflect efficient management of working capital, which can lead to a higher valuation. This is relevant regardless of whether the company is a pre-revenue startup funded by venture capital, or a multinational corporation funded through cash flow.

Businesses of every size, in every industry, need sufficient cash reserves to manage risk and support growth.

Healthy liquidity ratios provide flexibility for companies to pursue acquisitions, expand into new markets, and fund strategic initiatives without diluting ownership through equity financing.

Liquidity ratios are frequently used in comparative valuation models. Companies with strong ratios tend to command higher valuation multiples compared to industry peers.

This becomes especially important when a company is looking to secure additional funding through either debt or equity financing.

Securing Funding

Liquidity ratios play a key role in both debt and equity fundraising. Lenders carefully consider these ratios to gauge a company’s risk of default. Liquidity ratios are some of the most important financial ratios to analyze a company’s financial health. High liquidity ratios suggest that a business can meet its short-term obligations, reducing perceived lending risks.

This can translate to favorable loan terms, such as lower interest rates and flexible repayment periods. Companies with low liquidity ratios may struggle to secure loans or credit lines, over risk that the company may not be able to generate sufficient cash to meet the payment structure.

For equity financing, investors consider liquidity ratios to assess a company’s financial stability. Strong ratios inspire investor confidence, making it easier to attract equity investment.

Trends and Benchmarks in SaaS Liquidity Ratios

Every one of the liquidity ratios that we’ve discussed has one benchmark in common. If the number is below 1, a company has a problem.

This essentially means that debts are higher than liabilities, or MRR/ARR is shrinking rather than growing.

That isn’t to say that there aren’t sometimes situations where liquidity ratios can drop below one. Timing of large R&D expenses or other capital investments can drop cash reserves for a time, for example. This isn’t necessarily a problem as long as there is a plan to address the issue, such as the ability to refinance short term debt due to strong cash flow.

Generally speaking, a good current ratio is considered to be between 1.5 and 3.

Here are some recent examples of industry Current Ratios for large software companies:

As mentioned above, a SaaS Quick Ratio considers new MRR/ARR once accounting for churn. A number above 4 is considered to be a good benchmark to aim for, with anything below 1 an issue that needs to be addressed.

Leveraging Mosaic for Liquidity Analysis

Liquidity ratios are obviously important, but they don’t necessarily tell the whole story. That’s why finance teams need to analyze and monitor a wide range of different financial metrics to track the overall health of the company.

This can mean a ton of manual work building and updating models, while attempting to keep track of spreadsheet versions that change almost daily. That’s where Mosaic comes in.

The Mosaic platform provides a single source of truth for all of your financial data, including sophisticated modeling tools and scenario planning capabilities. Users can setup custom dashboards that allow them to see a real time view of metrics like the SaaS Quick Ratio, and monitor it over time, without the need to manually collate or calculate your data.