A liquidity ratio is a type of financial ratio used to determine a company’s ability to pay its short-term debt obligations. The metric helps determine if a company can use its current, or liquid, assets to cover its current liabilities
Three liquidity ratios are commonly used – the current ratio, quick ratio, and cash ratio. In each of the liquidity ratios, the current liabilities amount is placed in the denominator of the equation, and the liquid assets amount is placed in the numerator.
Given the structure of the ratio, with assets on top and liabilities on the bottom, ratios above 1.0 are sought after. A ratio of 1 means that a company can exactly pay off all its current liabilities with its current assets. A ratio of less than 1 (e.g., 0.75) would imply that a company is not able to satisfy its current liabilities.
A ratio greater than 1 (e.g., 2.0) would imply that a company is able to satisfy its current bills. In fact, a ratio of 2.0 means that a company can cover its current liabilities two times over. A ratio of 3.0 would mean they could cover their current liabilities three times over, and so forth.
What is Liquidity Ratio
Liquidity Ratio is a measure used for determining a company’s ability to pay off its short-term liabilities.
This ratio reflects whether an individual or business can pay off short-term dues without any external financial assistance. Considering the liquid assets, present financial obligations are analysed to validate the safety limit of a company.
Formulas
Under liquidity ratio there are several more ratios, which come into the picture for checking how financially, sound a company is:
I. Current Ratio
II. Acid Test Ratio or Quick Ratio
III. Absolute Liquidity Ratio
IV. Basic Defense Ratio
Current Ratio
This ratio measures the financial strength of the company. Generally, 2:1 is treated as the ideal ratio, but it depends on industry to industry.
Formula: Current Assets/ Current Liability, where
A. Current Assets = Stock, debtor, cash and bank, receivables, loan and advances, and other current assets.
B. Current Liability = Creditor, short-term loan, bank overdraft, outstanding expenses, and other current liability.
Acid Test Ratio or Quick Ratio
This ratio is the best measure of liquidity in the company. This ratio is more conservative than the current ratio. The quick asset is computed by adjusting current assets to eliminate those assets which are not in cash.
Generally, 1:1 is treated as an ideal ratio.
Formula: Quick Assets/ Current Liability, where,
Quick Assets = Current Assets – Inventory – Prepaid Expenses
Absolute liquidity ratio
This ratio measures the total liquidity available to the company. This ratio only considers marketable securities and cash available to the company. This ratio only tests short-term liquidity in terms of cash, marketable securities, and current investment. Formula: Cash + Marketable Securities / Current Liability
Basic Defense Ratio
This ratio measures the no. of days a company can cover its Cash expenses without the help of additional financing from other sources.
Formula: (Cash + Receivables + Marketable Securities) ÷ (Operating expenses +Interest + Taxes) ÷ 365
FAQs
What are liquidity ratio examples?
Some significant types of liquidity ratios are current ratio, quick ratio, cash ratio, etc.
What is the difference between solvency and liquidity?
Liquidity stands for the money that covers the short-term financial obligation of a company. Contrarily, solvency implies an organisation’s ability to pay off the total debt while continuing the business operations. The liquidity ratio is an essential part of the account solvency of a company.