What It Measures
Liquidity ratios are a set of ratios or figures that measure a company’s ability to pay off its short-term debt obligations. This is done by measuring a company’s liquid assets (including those that might easily be converted into cash) against its short-term liabilities.
There are a number of different liquidity ratios, which each measure slightly different types of assets when calculating the ratio. More conservative measures will exclude assets that need to be converted into cash.
Why It Is Important
In general, the greater the coverage of liquid assets to short-term liabilities, the more likely it is that a business will be able to pay debts as they become due while still funding ongoing operations. On the other hand, a company with a low liquidity ratio might have difficulty meeting obligations while funding vital ongoing business operations.
Liquidity ratios are sometimes requested by banks when they are evaluating a loan application. If you take out a loan, the lender may require you to maintain a certain minimum liquidity ratio, as part of the loan agreement. For that reason, steps to improve your liquidity ratios are sometimes necessary.
How It Works in Practice
There are three fundamental liquidity ratios that can provide insight into short-term liquidity: current, quick, and cash ratios. These work as follows:
This is a way of testing liquidity by deriving the proportion of assets available to cover current liabilities, as follows:
Current ratio = Current assets ÷ Current liabilities
Current ratio is widely discussed in the financial world, and it is easy to understand. However, it can be misleading because the chances of a company ever needing to liquidate all its assets to meet liabilities are very slim indeed. It is often more useful to consider a company as a going concern, in which case you need to understand the time it takes to convert assets into cash, as well as the...