Liquidity Ratio: Examples, Formulas, How to Calculate

Liquidity Ratio: Definition, Calculation & Analysis

You’ve probably heard before that the current ratio is the ‘standard test’ of a company’s liquidity position. The current ratio also sheds light on the overall debt burden of the company. If a company is weighted down with a current debt, its cash flow will suffer. A higher current ratio is always more favorable than a lower current ratio because it shows the company can more easily make current debt payments.

Liquidity Ratio: Definition, Calculation & Analysis

It is calculated by taking total current assets less its inventory divided by the current liabilities. With liquidity ratios, current liabilitiesare most often compared to liquid assets to evaluate the ability to cover short-term debts and obligations in case of an emergency. The current ratio is the simplest liquidity ratio to calculate and interpret. Anyone can easily find the current assets and current liabilities line items on a company’s balance sheet.

What is a Good Liquidity Ratio?

Comparing firms of various sizes and profiles using liquidity ratio analysis is less effective. Analysts can follow changes in the firm by comparing historical periods to current operations. A greater liquidity ratio, in general, indicates that a business is more liquid and has better coverage of its outstanding loans.

Liquidity Ratio: Definition, Calculation & Analysis

In this lesson, learn what is a liquidity ratio and how to calculate the three commonly used liquidity ratios. Current Assets is an account on a balance sheet that represents the value of all assets that could be converted into cash within one year. Solvency, on the other hand, is a firm’s ability to pay long-term obligations.

Operating Margin Formula & Definition Explained

For a more comprehensive analysis, you can add other types of financial ratios to the template. Current liabilities, generally used as the denominator for these ratios, usually refer to debt the company must pay back within a year. There are different types of liquidity ratios, and each considers a narrower subset of current assets. These ratios are frequently analyzed together with solvency ratios, which focus on paying off long-term financial obligations, including any due interest.

So, to calculate it, we add up cash and cash equivalents, short-term investments, and accounts receivable and then divide by current liabilities. Liquidity ratios are important metrics when evaluating a company’s short-term financial health. Because they measure a business’s ability to pay off current liabilities, short-term lenders and investors can use them to assess risk.

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If inventory turns into cash much more rapidly than the accounts payable become due, then the firm’s current ratio can comfortably remain less than one. Inventory is valued at the cost of acquiring it and the firm intends to sell the inventory for more than this cost. The sale will therefore generate substantially more cash than the value of inventory on the balance sheet. Low current ratios can also be justified for businesses that can collect cash from customers long before they need to pay their suppliers.

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The acid-test ratio is similar to the current ratio except the value of inventory is omitted from the calculation. A low liquidity ratio means a firm may struggle to pay short-term obligations. A high liquidity ratio indicates that a business is holding too much cash that could be utilized in other areas. Activity ratios, also called efficiency ratios, measure the effectiveness of a firm’s use of resources, or assets.

We calculate them by comparing the components in current assets with current liabilities. As the numerator, we use the total current assets or several accounts in it, considering Liquidity Ratio: Definition, Calculation & Analysis how liquid they are. Therefore, extremely high levels of liquidity ratio protect the business against liquidity crisis, but at the cost of lower profit from operations.

Why do we calculate liquidity ratio?

The liquidity ratio is used to measure the the ability of the company to cover its short-term debt obligations. This helps to illustrate the financial stability of the company to investors and lenders.

It is logical because the cash ratio only considers cash and marketable securities in the numerator, whereas the current ratio considers all current assets. Current ratio, called so because it compares current assets to current liabilities. If you have a balance sheet forecast to work from this is the easiest ratio to calculate – just takes your current assets line and divide it by current liabilities. Lenders and investors may use liquidity ratio calculations to determine how healthy your business is.

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