• Liquidität

Calculating liquidity – formulas for the 1st, 2nd and 3rd degree

Calculating liquidity – formulas for the 1st, 2nd and 3rd degree

The ability to pay is one of the decisive success factors of a company. To ensure it, business economists and finance managers draw on various key figures. The formula for the liquidity ratio of the 2nd degree is particularly important here, because it shows whether short-term liabilities can be covered not only by cash but also by open receivables. In this article you will learn how to calculate liquidity and why these key figures matter not only in business economics but in economics as a whole.

The essentials in brief – summary:

  • The formulas for the liquidity ratios of the 1st, 2nd and 3rd degree are central methods for assessing the ability to pay.
  • The formula for the liquidity ratio of the 2nd degree is the most relevant in practice, because it sets cash + short-term receivables against short-term liabilities.
  • Overview of the formulas:
  1. degree = liquid funds ÷ short-term liabilities (10–30%)
  2. degree = (liquid funds + short-term receivables) ÷ short-term liabilities (100–120%)
  3. degree = (liquid funds + short-term receivables + inventories) ÷ short-term liabilities (120–200%)
  • Companies use the formulas to identify bottlenecks early and take action.
  • In economics, central banks steer liquidity through the money supply and base rates.
  • Times of crisis (e.g. Covid) show how important sufficient liquidity and state support are.

Contents

Definitions at a glance

How do you calculate the liquidity ratio of the 2nd degree? Formulas help not only with this important key figure, but with those of the 1st, 2nd and 3rd degree. Before we go into calculation and planning in more detail, we would first like to establish the definition. It differs slightly depending on the area of finance, even though the basis is fundamentally the same.

The term liquidity is used both in business economics and in economics:

  • In business economics, a company with sufficient liquidity is able to meet all payment obligations in full whenever they fall due. In practice, the formula for the liquidity ratio of the 2nd degree plays a particular role here, because it shows whether liquid funds and short-term receivables can cover short-term liabilities.
  • In economics, the two sub-areas of microeconomics and macroeconomics use the term.
    • In microeconomics it means the possibility of converting fixed assets into money.
    • In macroeconomics, liquidity denotes a particular amount of money present in the economy of a state.
  • In capital market theory, market liquidity denotes the volume of goods or capital contracts that can be traded at any time without a single transaction noticeably affecting the market price.

Whatever the context, it is important to be able to calculate the liquidity ratios of the 1st, 2nd and 3rd degree (using formulas), because they are an important key figure for the ability of companies and states to pay.

Liquidity in the company

Every company regularly incurs costs and other payment obligations. These include wages and salaries, social security contributions, rent, taxes, insurance premiums as well as instalments and interest for loans. Supplier invoices, expenditure on repairs and maintenance and outlays for the marketing budget or for new vehicles and machinery also have to be paid.

Every type of cost has a particular due date on which payment has to be made. Suppliers, service providers and other vendors either insist on immediate payment or grant a payment term. Salary payments have to be made monthly. Loan instalments, taxes and insurance premiums are paid monthly or at particular intervals, such as quarterly, half-yearly or once a year. This means that high expenditure falls due on particular dates, which has to be taken into account accordingly in the planning and calculation of liquidity.

The business management department of a company has the task of ensuring that sufficient liquid funds are available on the respective due dates to meet all payment obligations on time and in full. The formula for the liquidity ratio of the 2nd degree is used here in particular, because in addition to cash it also takes short-term receivables into account and thus provides a realistic picture of the ability to pay.

To do so, the business economist has to calculate the three degrees (1st, 2nd, 3rd) of liquidity (formulas help here), which show whether the company’s liquid funds are sufficient or whether measures to safeguard its ability to pay have to be taken in good time.

Calculating the liquidity ratios of the 1st, 2nd and 3rd degree with formulas in companies – how it works

The goal of successful company management is to ensure optimal financial agility. This means that there should not be too much money sitting in the business account, since it causes costs and yields no return. At the same time, on the due dates of payment obligations there has to be sufficient cover in order to avoid overdraft interest.

Beyond that, the available capital should be in a healthy relation to the company’s debts. To take all of these aspects into account, every single liquidity ratio is an important instrument for managing a company’s financial flexibility.

Calculating the liquidity ratios of the 1st, 2nd and 3rd degree – formulas galore

Whether a business economist or another person responsible for finance wants to calculate the cash ratio or a higher liquidity ratio – formulas and the underlying data are inevitably the starting point. Many people shy away from complicated calculation rules and algorithms, but the basics are often quicker and easier to understand than you think. We would like to explain them in more detail below.

Liquidity ratio of the 1st degree

Formula and definition for calculating direct, conservative liquidity:

  • Other names: cash ratio or cash liquidity
  • Formula for the calculation: liquid funds : short-term liabilities × 100 [%]
  • Recommended value: 10% – 30%

A company’s liquid funds are not only the balance in the business account or in accounts at other banks and at the Deutsche Bundesbank. Cash on hand, cheques and discountable bills of exchange also count. Liquid funds are characterised by being available immediately and without restriction to settle invoices.

Short-term liabilities include loans or supplier credit with a remaining term of less than a year. Provisions for taxes, bonus payments to the workforce, repairs, new acquisitions or other purposes are also among the near-term obligations. A company can additionally use inventories and receivables to settle payments falling due soon. When companies want to calculate the first degree of liquidity, the recommended value is accordingly set low.

Liquidity ratio of the 2nd degree

Formula and definition for calculating collection-based liquidity:

  • Other names: acid test, quick ratio or collection-based
  • Formula for the calculation: (liquid funds + short-term receivables) : short-term liabilities x 100 [%]
  • Recommended value: 100% – 120%

To calculate the second degree, the formula for the liquidity ratio of the 2nd degree comes into play, in which short-term receivables are also taken into account. These relate to payment claims against debtors with a payment term of less than a year. But what does the liquidity ratio of the 2nd degree actually tell you? A value below 100% in this calculation indicates that short-term liabilities are not fully covered by quickly available liquid funds. In such a case the company’s management has to intervene, establish the causes and, if necessary, take countermeasures.

The key figure is also known as the acid test, because banks use it to assess creditworthiness. The so-called “banker’s rule” says that the target or benchmark value for the liquidity ratio of the 2nd degree should be above 100%.

Liquidity ratio of the 3rd degree

Formula and definition for calculating turnover-based liquidity:

  • Other names: current ratio or turnover-based
  • Formula for the calculation: (liquid funds + short-term receivables + inventories) : short-term liabilities x 100 [%]
  • Recommended value: 120% – 200%

In order to calculate the third degree of liquidity, the company’s inventories have to be included in addition to the factors already taken into account in the first two liquidity ratios. These are the stocks of raw materials, auxiliary materials, operating supplies, unfinished goods and finished but as yet unsold products shown in the balance sheet. Advance payments for required materials also count as inventories.

A value of less than 120% indicates that the entire capital tied up in current assets is not sufficient to cover short-term liabilities in full. A result of more than 200%, by contrast, can indicate that the company has too many raw materials or trade goods in stock, tying up an excessive amount of capital. This tied-up liquidity is then not available to cover running costs or to repay short-term liabilities, which can ultimately lead to a financial bottleneck.

Calculating liquidity in economics – effects on the state budget

It is not only companies that have to calculate their liquidity ratios regularly and check their ability to pay. The term liquidity also crops up frequently in business news in connection with national and international monetary policy. While in business economics concrete key figures are calculated, for example with the formula for the liquidity ratio of the 2nd degree, in order to check the short-term ability of companies to pay, states look at liquidity on a larger scale by steering the money supply. Each state pursues its own monetary policy goals in order to strengthen the country’s economy. By steering the amount of money in circulation, a state can influence interest rates, prices and demand for goods and services. In Europe this regulation is handled by the national central banks in close coordination and consultation with the European Central Bank (ECB).

Across Europe, governments and central banks work to secure price stability in the individual countries through a balanced currency and financial policy. In Germany these measures are determined by the federal government and the Deutsche Bundesbank in Frankfurt am Main. The Bundesbank regularly establishes how much money is in circulation and available to the economy. Changes in this circulation of money have a direct effect on price developments, inflation and the country’s economic growth. To understand and anticipate these consequences fully, it is important to calculate liquidity regularly in the state economy as well.

The money supply is steered through the base rate, which the Deutsche Bundesbank or the ECB can lower or raise as required. To analyse better and decide whether an adjustment of the base rate is necessary, central banks divide the money supply into the categories M0, M1, M2 and M3. Each central bank defines them somewhat differently. There is consensus, however, that only money held by private individuals, companies and other so-called non-banks is taken into account.

Here is the breakdown of the money supply according to the European Central Bank (ECB):

  • M0: covers the cash held in the tills and cash machines of credit institutions, as well as customer funds deposited by banks and savings banks with the central bank of their respective country.
  • M1: consists of cash and the balances in the current accounts of consumers and companies.
  • M2: includes the money supply M1 as well as balances in overnight deposit accounts or savings books with a statutory notice period of up to three months and fixed-term deposits or other forms of investment with a term of up to two years.
  • M3: comprises M2 plus holdings in bank bonds, money market funds and other money market instruments as well as repurchase agreements with a term of up to two years.

The connection between economic and business liquidity

One important task of the central banks becomes especially apparent in times of crisis. The ECB, for example, decided to make additional liquidity available because of the worldwide Covid crisis. But how does the ECB increase it in Europe, and what does that mean for entrepreneurs? How does this policy measure help to get through the crisis and secure the survival of the company?

The answer to these questions is that the ECB and the individual central banks have to ensure that companies are optimally supplied with financial resources. To that end, businesses have to be provided with low-interest loans and subsidies as well as further support. While states influence liquidity across the economy through measures such as loans or base rates, companies calculate their ability to pay using business methods, for example with the formula for the liquidity ratio of the 2nd degree. That way they can use the available support more effectively and get through economic challenges.

An interesting look back: Covid support measures in Europe

The European Council had already agreed a number of support measures with which European states can secure and support the financial stability of companies:

  • European short-time work allowance and support programme (SURE)
  • Corporate loans for small and medium-sized enterprises (SMEs) through a guarantee fund of the European Investment Bank
  • Loans from the European Stability Mechanism (ESM) with few conditions
  • The EU recovery fund

For European states this means having to calculate and adjust their own economic liquidity in order to ensure that sufficient funds are available to implement these programmes. Companies, in turn, can only make targeted use of such support if they keep a close eye on their ability to pay, for example with the formula for the liquidity ratio of the 2nd degree, which shows whether short-term obligations can be covered even under crisis conditions. Alongside Europe-wide support, the individual countries also offer specific liquidity assistance intended to relieve companies of every size.

Financial support in Germany

In Germany various measures were agreed which are handled through the Kreditanstalt für Wiederaufbau (KfW):

  • Rapid loan for companies with more than ten employees
  • Special corporate loans for young and long-established businesses
  • Syndicated financing from €25 million

Alongside the KfW’s low-interest loans, entrepreneurs can also draw on support from the federal government and the federal states. This comprises grants, emergency aid, short-time work allowance, loan guarantees and the interest-free deferral of tax payments or social security contributions. For SMEs, the self-employed and freelancers there is unbureaucratic emergency aid available that does not have to be repaid.

To optimise liquidity, VAT was additionally reduced by three per cent for six months. These measures require companies to calculate and monitor their operational liquidity in order to assess precisely the effects of the tax relief and the support programmes on their financial position.

Overview of support in Austria

In Austria, too, companies receive extensive support from the state. A Covid support fund was set up which offers targeted help to established companies of every size as well as to start-ups, the newly self-employed setting up a business, freelance contractors, micro-entrepreneurs and one-person businesses (EPU). The most important forms of support in Austria include:

  • Working capital financing
  • Bridging finance for tourism businesses
  • Simplified secondment of employees to another business
  • Tax deferral or payment of taxes in instalments
  • Short-time work allowance
  • Guarantees and sureties to secure loans

Here too it is important that companies not only calculate their liquidity ratios of the 1st, 2nd and 3rd degree with formulas, and do so very precisely, but also make effective use of state support. Tax deferral, among other things, can directly increase available liquidity, while bridging finance secures the ability to pay in times of crisis.

Liquidity as a decisive factor for the economy as a whole

Sufficient liquidity ensures that a company can meet its payment obligations and remains active in the market. Formulas for the liquidity ratios of the 1st, 2nd and 3rd degree are a decisive help in this. In economics, stability depends decisively on the economy as a whole being supplied with enough money. That is why one of the most important tasks of monetary policy is to calculate and steer this liquidity in order to guarantee the economic stability of a state.

This becomes particularly clear in times of crisis, when the government has to ensure through targeted measures that the necessary liquidity is available to keep the economy running.

FAQ

Can a company with a liquidity ratio of the 2nd degree of 100% still run into payment difficulties?

Yes, because short-term receivables may not be immediately collectable or payments may be delayed – the formula only shows theoretical cover.

How can you improve the liquidity ratio of the 2nd degree at short notice?

By collecting open receivables faster, reducing expenditure or arranging targeted credit lines – not only through cash reserves.

Why do banks pay more attention to the liquidity ratio of the 2nd degree than to the other degrees?

It reflects the real short-term ability to pay, since receivables often turn into money soon, whereas inventories are less liquid.

Liquiplanung und Liquidität

Credits: Photo from unsplash, by Markus Spiske