Liquidity Ratio Overview, Types, Importance, Example

A firm might have a build-up of inventory because of low sales, and a metric such as the current ratio would show a false projection of the company’s liquidity. Assets are listed on a firm’s balance fixed asset turnover ratio formula example calculation explanation sheet and can have cash in the bank, marketable securities, current stock, goodwill, plant, machinery, etc. Liquid assets can be swiftly and easily converted into cash or cash equivalents.

• Current assets include cash and short-term investments, accounts receivable, inventory (work in process), marketable securities, and prepaid expenses.
• Generally, a company with a higher solvency ratio is considered to be a more favorable investment.
• Accounting liquidity measures the ease with which an individual or company can meet their financial obligations with the liquid assets available to them—the ability to pay off debts as they come due.
• It’s a ratio that tells one’s ability to pay off its debt as and when they become due.

Although the current and acid test ratios evaluate a firm’s liquidity, there is a subtle difference between them. The current ratio is a more aggressive estimate as it encompasses more items. Current assets are highly liquid assets such as cash, inventory, and accounts receivables. The use of these metrics helps evaluate whether a firm can cover its current liabilities with its current assets. However, if liquidity is interpreted more narrowly and the quick ratio is considered, the ratio is lower, but in the example it is still sufficient at 213%. The company can pay its liabilities in full within a short time without having to liquidate assets from inventories.

Absolute liquidity ratio

The quick ratio is similar to the current ratio as both are the ratio of existing assets to current liabilities. Three different formulas can be used to calculate liquidity – the current ratio, the quick ratio, and the cash ratio. They provide insight into a company’s ability to repay its debts and other liabilities out of its liquid assets. To understand how liquidity ratios can be used to assess a company’s financial condition, consider this hypothetical example of two companies, using a side-by-side comparison of their balance sheets. Also, when using liquidity ratios, it’s essential to put them in the context of other metrics and company trends to provide a more accurate picture of a company’s financial health. Since the three ratios vary by what is used in the numerator of the equation, an acceptable ratio will differ between the three.

It leaves out current assets such as inventory and prepaid expenses because the two are less liquid. So, the quick ratio is more of a true test of a company’s ability to cover its short-term obligations. These liquidity ratios are used to measure a company’s ability to pay its short-term obligations. Liquidity ratios provide information about a company’s ability to meet its short-term financial obligations by comparing current assets to current liabilities.

However, taking on too much debt can also lead to a liquidity crisis and increase a company’s chances of defaulting on its debt if market conditions change. Liquidity ratios are very important as you can use them to evaluate how well a company can convert its assets into cash. A liquidity ratio is a type of ratio that allows you to determine how well a company can pay for its debt without having to use external funding sources. A higher current ratio around two(2) is suggested to be ideal for most of the industries while a lower value (less than 1) is indicative of a firm having difficulty in meeting its current liabilities. It means that this company collected its accounts receivable 2-times faster than it sold credit and had an average AR balance of just one-fifth of its annual credit sales.

Understanding Liquidity

The idea is to see if the company’s total assets are enough to theoretically pay off all its liabilities. Analyzing the trend of these ratios over time will enable you to see if the company’s position is improving or deteriorating. Pay particular attention to negative outliers to check if they are the result of a one-time event or indicate a worsening of the company’s fundamentals. A comparison of financial ratios for two or more companies would only be meaningful if they operate in the same industry. This is a very important criterion that creditors check before offering short term loans to the business. An organisation which is unable to clear dues results in creating impact on the creditworthiness and also affects credit rating of the company.

What Is Liquidity Ratio (Explained: All You Need To Know)

For example, if Company XYZ has a patent on a specific product, the patent represents an intangible asset. Although they have some limitations, these ratios remain critical in credit analysis, investment decisions, and management evaluation. Liquidity ratios can be manipulated through financial engineering, resulting in misleading outcomes that may not reflect the actual financial health of a company. For example, a loan from another firm may be due in slightly over 365 days, so it would not be listed under current liabilities. Is a cost incurred when debtors cannot pay their debts and default on their loans?

Solvency Ratios

Working capital issues will put restraints on the rest of the business as well. This ratio only considers a company’s most liquid assets – cash and marketable securities. They are the assets that are most readily available to a company to pay short-term obligations. In the example above, the rare book collector’s assets are relatively illiquid and would probably not be worth their full value of $1,000 in a pinch.

He served clients, including presenting directly to C-level executives, in digital, strategy, M&A, and operations projects. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. These names tend to be lesser known, have lower trading volume, and often have lower market value and volatility.

They are widely used for this purpose and for deciding about financing mix, capital structure, investment, etc. Liquidity ratios can be affected by business cycles, as companies may have fluctuating cash flow and working capital requirements during different stages of the cycle. A 1.1 ratio means the company has enough cash to cover current liabilities. Inventory is less liquid than accounts receivable because the product must first be sold before it generates cash (either through a cash sale or sale on account). Even if such companies have enough assets to meet these needs in the long run, an ability to pay them in the short term could potentially lead to bankruptcy.

For example, if a person wants a $1,000 refrigerator, cash is the asset that can most easily be used to obtain it. If that person has no cash but a rare book collection that has been appraised at $1,000, they are unlikely to find someone willing to trade the refrigerator for their collection. Instead, they will have to sell the collection and use the cash to purchase the refrigerator.