• Post category:Finance

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 it’s self is an ability of a company to pay its debt in short run, and abilitiy to pay unexpected needs as cash. If the company can’t repay its debt, this will cause the problem to the company, in the worse case the company may going to bankruptcy if they can’t really repay the debt.

The most commonly use of liquidity ratio to measure the liquidity of a business is the current ratio and quick ratio that you can calculation with these 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

Business 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 how the company can re-pay their debt in 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, extreamly high levels of liquidity ratio protect the business against liquidity crisis, but at the cost of lower profit from operations. If the business hoard their asset to repay future debt, this mean the business can’t use these asset to generate profit. This is why high liquidity levels sometimey 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. Calcuated as current assets divided by current liabilities.

Current ratio = Current assets ÷ Current liabilities

Liquidity Ratio Formula Calculate example
Current Ratio is one of mostly use to analyze the business’ liquidity.

However, 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 oder to liquidate them (these low liquidity asset 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 sometime high current ratio might indicate that the firm has too much cash, receivables, and inventory relative to the case that the business not being managed these current assets efficiently.

According to these issue, to analysis the company’s liquidity, we also use the quick ratio to measure the liquidity along with current ratio.

Quick ratio is a measure the dollars of more liquidity assets without relying on inventory sales which include cash, marketable securities, and account receivable compare to current liabilities.

Quick ratio = (Cash + Short term investment + Receivables) ÷ Current liabilities