Let us know more about the liquidity ratios

The liquidity ratio measures how liquid the company’s assets are in comparison to its current liabilities. In simple words, it evaluates any company’s ability to meet its short-term obligations. 

Main types of liquidity ratio – 

Current ratio: The current ratio is the most frequently used ratio to measure a company’s liquidity as it is a quick & easy measure to understand the relationship between the current assets and current liabilities. It compares the assets of a company, which can convert into cash with the liabilities that it must pay off within a year. 

Current ratio formula = current assets/current liabilities

The current ratio will provide a rough estimate of whether the company can survive for a year or not. If current assets are greater than current liabilities, it can be interpreted as the company can liquidate its current assets along with paying off its current liabilities and survive at least for one operating cycle. 

Quick ratio: Sometimes, current assets may contain huge amounts of inventory, prepaid expenses, etc. This may skew the current ratio interpretations as these are not very liquid. To address this issue, if only the most liquid assets like cash & cash equivalents and receivables are considered, then it provides a better picture of the coverage of short-term obligations. This ratio is known as the quick ratio or the acid test ratio. 

Quick ratio formula = (cash & cash equivalents + accounts receivables)/current liabilities

Accounts receivables are more liquid than inventories. In addition, there can be uncertainty related to the true value of the inventory realised as some of it may become obsolete, prices may change, or it may become damaged. It should be noted that a low quick ratio may not always mean liquidity issues for the company. This ratio is not suitable for some businesses like restaurants, supermarkets, etc. as it sells on a cash basis. In these businesses, there are no receivables; however, there may be a huge pile of inventory. 

Cash ratio: It considers only the cash & cash equivalents (there are the most liquid assets within the current assets). If the company has a higher cash ratio, it is more likely to be able to pay its short-term liabilities. 

Cash ratio formula = cash & cash equivalents/current liabilities

The cash ratio is the ultimate liquidity test. If this number is large, it can be assumed that the company has enough cash in its bank to pay off its short-term liabilities.