What is Liquidity Ratio
Liquidity Ratio is a measure of company’s ability to pay its short-term liabilities. The liquidity ratio is a relationship between the liquidity asset with total current liabilities in the balance sheet.
Liquidity itself is an ability of a company to pay its debt in the short run, and the ability to pay unexpected needs as cash. If the company can’t repay its debt, this will cause a problem to the company, in the worse case the company may going to bankruptcy if they can’t really repay the debt.
The most common use of liquidity ratio to measure the liquidity of a business is the current ratio and quick ratio that you can calculate with the following formula.
Current ratio = Current assets ÷ Current liabilities
Quick ratio = (Cash + Short term investment + Receivables) ÷ Current liabilities
Both liquidity ratios are answer the question: can the business obtain short term financing when necessary? The higher the liquidity ratios, the less liquidity risk a firm has.
Key Points
- Liquidity ratio is a measure of company’s ability to pay its short-term liabilities (current liabilities in the balance sheet).
- The widely use of liquidity ratio is the current ratio and quick ratio.
- The more value of liquidity ratio, reflect the higher liquidity of the business. Thus, the higher the liquidity ratios, the less liquidity risk a firm has.
Meaning of Liquidity Ratio
Businesses need cash and other liquid assets (current assets) to pay their short-term debt as they come due. WE use the liquidity ratio to figure out how the company can re-pay their debt in the short run.
The liquidity ratio measures the dollars of liquid assets available to pay each dollar of current liabilities, which means the more value of liquidity ratio, reflect the higher liquidity of the business.
Therefore, extremely high levels of liquidity ratio protect the business against liquidity crisis, but at the cost of lower profit from operations. If the business hoards their asset to repay future debt, this means the business can’t use these assets to generate profit. This is why high liquidity levels sometimes show bad or indecisive management.
The managers must consider between the advantage of being liquid with the disadvantages of reduced profits.
Liquidity Ratio Calculate
The most commonly used liquidity ratios are the current ratio and the quick ratio. Calculated as current assets divided by current liabilities.
Current ratio = Current assets ÷ Current liabilities
However, the issue of the current ratio is, it might also indicate that the business has too much old inventory and too many old accounts receivable that the company must sell them in order to liquidate them (these low liquidity assets make total current assets seem high).
If the company can’t sell them, it has a chance to become bad debts. In other words, it’s become “ZERO” if u can’t sell them.
This is why sometimes high current ratio might indicate that the firm has too much cash, receivables, and inventory relative to the case that the business is not being managed these current assets efficiently.
According to these issues, to analyze the company’s liquidity, we also use the quick ratio to measure the liquidity along with the current ratio.
The quick ratio is a measure the dollars of more liquidity assets without relying on inventory sales which include cash, marketable securities, and account receivable compared to current liabilities.
Quick ratio = (Cash + Short term investment + Receivables) ÷ Current liabilities
