Liquidity ratios
The liquidity ratio is a financial ratio that measures a company’s ability to meet its short-term obligations with its current assets. In the construction industry, where cash flow can be unpredictable and expenses can be front-loaded, monitoring liquidity ratios is particularly important to ensure that the company has enough liquidity to operate efficiently and cover ongoing expenses.
There are several different liquidity ratios that can be used to measure a company’s liquidity, but two of the most commonly used ratios are the current ratio and the quick ratio.
The current ratio is calculated by dividing current assets by current liabilities. Current assets include cash and cash equivalents, accounts receivable, and inventory, while current liabilities include accounts payable, short-term debt, and other current liabilities. The current ratio provides an indication of the company’s ability to pay its short-term liabilities using its current assets. A current ratio of 1 or higher is generally considered to be good, as it indicates that the company has enough current assets to cover its current liabilities.
The quick ratio, also known as the acid-test ratio, is a more conservative measure of liquidity than the current ratio. The quick ratio is calculated by subtracting inventory from current assets and then dividing the result by current liabilities. The quick ratio provides an indication of the company’s ability to pay its short-term liabilities using its most liquid assets (i.e., assets that can be easily converted into cash). A quick ratio of 1 or higher is generally considered to be good, as it indicates that the company has enough liquid assets to cover its current liabilities.
While liquidity ratios are an important tool for monitoring a company’s liquidity, it is important to keep in mind that they are just one piece of the financial puzzle. A company with a high liquidity ratio may still face other financial challenges, such as high debt levels or poor profitability. As such, it is important to use liquidity ratios in conjunction with other financial ratios and metrics to get a more complete picture of the company’s financial health.

Here are 2 simple examples illustrating liquidity ratios in the context of a construction business.

Example 1: ABC Construction is a mid-sized construction company that specializes in commercial building projects. At the start of the year, the company had $500,000 in current assets and $250,000 in current liabilities. Based on these numbers, ABC Construction has a current ratio of 2:1 ($500,000 ÷ $250,000). This means that the company has $2 in current assets for every $1 in current liabilities, indicating that the company is in a good position to pay its short-term debts.
However, as the year progresses, ABC Construction starts experiencing cash flow problems due to delays in receiving payments from customers. By the end of the year, the company’s current assets have decreased to $350,000, while its current liabilities have increased to $400,000. This results in a current ratio of 0.88:1 ($350,000 ÷ $400,000), indicating that the company may struggle to pay its short-term debts. To address this issue, ABC Construction may need to take steps to improve its cash flow, such as renegotiating payment terms with customers or seeking financing to cover its short-term liabilities.

Example 2: XYZ Construction is a small construction company that specializes in residential remodeling projects. At the start of the year, the company had $200,000 in current assets and $100,000 in current liabilities. Based on these numbers, XYZ Construction has a current ratio of 2:1 ($200,000 ÷ $100,000), indicating that the company is in a good position to pay its short-term debts.
However, as the year progresses, XYZ Construction starts experiencing issues with slow-moving inventory (unsold projects). By the end of the year, the company’s inventory has increased to $75,000, while its current assets have decreased to $150,000. This results in a quick ratio of 1.33:1 (($150,000 – $75,000) ÷ $100,000), indicating that the company may struggle to pay its short-term debts using its most liquid assets. To address this issue, XYZ Construction may need to take steps to reduce its inventory levels, such as offering discounts on slow-moving projects or adjusting its procurement processes.
These examples illustrate how liquidity ratios can provide valuable insights into a construction company’s financial health. By monitoring liquidity ratios, companies can identify potential cash flow issues early and take steps to address them before they impact the company’s ability to operate or complete projects.

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