Liquidity ratios are accounting ratios that show the ability of a business to cover its near-term financial obligations. Overall, these show a company’s short-term financial health. Learn more about three of the most important liquidity ratios.
What is a Liquidity Ratio?
Liquidity ratios measure a company’s financial health and ability to meet its short- and long-term debt obligations as they come due. These ratios show the cash level of the company and its ability to turn other current assets into cash to meet obligations. There are three main liquidity ratios: the current ratio, the quick ratio, and the cash ratio.
The Current Ratio
The current ratio measures a company’s ability to pay its short-term obligations with short-term assets. This measure is the least strict of the three liquidity ratios as it includes all current assets in the calculation. The formula for the current ratio is:
Current ratio = current assets / current liabilities
For example, assume a firm has $5 million in current assets and $2 million in current liabilities. The current ratio is:
$5 million / $1 million = 5
This shows that the company has $5 of very liquid assets on hand for every $1 worth of current liabilities.
It’s an important measure of liquidity because by definition, current liabilities are due within one year. A higher current ratio is better, and it indicates that the company is stronger. If the current ratio is less than 1, the company can’t meet its obligations easily and may be in serious trouble.
The Quick Ratio
The quick ratio, also known as the acid test ratio, is slightly more strict than the current ratio. It measures a company’s ability to meet current liabilities with only quick assets. This ratio does not take into account certain current assets, such as inventory and prepaid expenses, which may not be as easily converted into cash as other current assets. It’s calculated as:
Quick ratio = (cash + cash equivalents + short-term investments + current receivables) / current liabilities
Using the current ratio example above, assume that of the company’s current assets, $3 million are inventory and $200,000 are prepaid expenses. The quick ratio is then:
($5 million – $3 million – $200,000) / $1 million = 1.8
This paints a different picture. Now, the company only has 1.8 times the current liability coverage. A higher quick ratio is better, indicating that the company is more liquid.
The Cash Ratio
The cash ratio is the strictest liquidity ratio, only taking cash and cash equivalents into account. It ignores short-term investments and current receivables because they may take up to a few days to convert to cash. The cash ratio is the purest liquidity measure. It’s calculated as:
Cash ratio = (cash + cash equivalents) / current liabilities
Using the previous examples, assume that of the company’s current assets, only $500,000 are cash and equivalents. Thus the ratio is:
$500,000 / $1 million = 0.5
The company only has 50 cents of cash to cover each $1 of current liabilities, which is a completely different picture.