Liquidity is a very critical part of a business. Liquidity is required for a business to meet its short term obligations. Liquidity ratios are a measure of the ability of a company to pay off its short-term liabilities.
Liquidity ratios determine how quickly a company can convert the assets and use them for meeting the dues that arise. The higher the ratio, the easier is the ability to clear the debts and avoid defaulting on payments.
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.
Let us now discuss the different types of liquidity ratios.
Types of Liquidity Ratio
There are following types of liquidity ratios:
- Current Ratio or Working Capital Ratio
- Quick Ratio also known as Acid Test Ratio
- Cash Ratio also known Cash Asset Ratio or Absolute Liquidity Ratio
- Net Working Capital Ratio
Let us know more in detail about these ratios.
Current Ratio or Working Capital Ratio
The current ratio is a measure of a company’s ability to pay off the obligations within the next twelve months. This ratio is used by creditors to evaluate whether a company can be offered short term debts. It also provides information about the company’s operating cycle. It is also popularly known as Working capital ratio. It is obtained by dividing the current assets with current liabilities.
Current ratio is calculated as follows:
Current ratio = Current Assets / Current Liabilities
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.
Also read:Difference Between Current Ratio and Quick Ratio
Quick Ratio or Acid Test Ratio
Quick ratio is also known as Acid test ratio is used to determine whether a company or a business has enough liquid assets which are able to be instantly converted into cash to meet short term dues. It is calculated by dividing the liquid current assets by the current liabilities
It is represented as
Quick Ratio = (Cash + Marketable securities + Accounts receivable) / Current liabilities
The ideal quick ratio should be one(1) for a financially stable company.
See more:Working Capital Turnover Ratio
Cash Ratio or Absolute Liquidity Ratio
Cash ratio is a measure of a company’s liquidity in which it is measured whether the company has the ability to clear off debts only using the liquid assets (cash and cash equivalents such as marketable securities). It is used by creditors for determining the relative ease with which a company can clear short term liabilities.
It is calculated by dividing the cash and cash equivalents by current liabilities.
Cash ratio = Cash and equivalent / Current liabilities
Net Working Capital Ratio
The net working capital ratio is used to determine whether a company has sufficient cash or funds to continue its operations. It is calculated by subtracting the current liabilities from the current assets.
Net Working Capital Ratio = Current Assets – Current Liabilities
Liquidity Ratio Formula
Here are the important liquidity ratio formulas in a tabular format.
| Liquidity Ratios | Formula |
| Current Ratio | Current Assets / Current Liabilities |
| Quick Ratio | (Cash + Marketable securities + Accounts receivable) / Current liabilities |
| Cash Ratio | Cash and equivalent / Current liabilities |
| Net Working Capital Ratio | Current Assets – Current Liabilities |
| |
Importance of Liquidity Ratio
Here are some of the importance of liquidity ratios:
- It helps understand the availability of cash in a company which determines the short term financial position of the company. A higher number is indicative of a sound financial position, while lower numbers show signs of financial distress.
- It also shows how efficiently the company is able to convert inventories into cash. It determines the way a company operates in the market.
- It helps in organising the company’s working capital requirements by studying the levels of cash or liquid assets available at a certain time.
Also see:
- Gaining Ratio
- Solvency Ratio
- Profitability Ratios
- New Profit Sharing Ratio
This concludes the article on the concept of liquidity ratios. It will provide ample information for the students to understand liquidity ratios which provides a solid basis for calculating the liquidity position of a company. For more such exciting concepts, stay tuned to BYJU’S.
Frequently Asked Questions on Liquidity Ratio
Q1
What is SLR?
SLR is known as the statutory liquidity ratio. It is the minimum percentage of the deposit that a commercial bank needs to maintain in the form of cash, securities and gold before offering credit to customers. Current SLR is 21.50% in India.
Q2
What is Liquidity Coverage Ratio?
Liquid coverage ratio is the proportion of high liquid assets that banks need to maintain short term debts or liabilities.
Q3
What is a good liquidity ratio?
A good liquidity ratio can be any value that is greater than 1. It indicates that a company is having a sound financial position and can meet short-term obligations efficiently.
Q4
What are three types of liquidity ratios?
The three types of liquidity ratios are the current ratio, quick ratio and cash ratio. These are useful in determining the liquidity of a company.
Q5
What are the most common liquidity ratios
The most common liquidity ratios are the current ratio and quick ratio. These are very useful ratios for calculating a company’s ability to pay short term liabilities.
FAQs
Liquidity ratios are a measure of the ability of a company to pay off its short-term liabilities. Liquidity ratios determine how quickly a company can convert the assets and use them for meeting the dues that arise. The higher the ratio, the easier is the ability to clear the debts and avoid defaulting on payments.
What are the liquidity ratios and their importance? ›
Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding.
How do you calculate the liquidity ratio? ›
To calculate this ratio, divide a company's total cash and cash equivalents by its total current liabilities. Here, a higher ratio indicates that the company has enough liquid assets to cover all its short-term obligations without selling any other assets.
What is the liquid ratio? ›
It's a ratio that tells one's ability to pay off its debt as and when they become due. In other words, we can say this ratio tells how quickly a company can convert its current assets into cash so that it can pay off its liability on a timely basis.
What is the formula for the liquid test ratio? ›
Formula: Quick Ratio = (Marketable Securities + Available Cash and/or Equivalent of Cash + Accounts Receivable) / Current Liabilities. Quick Ratio = (Current Assets – Inventory) / Current Liabilities.
What is the primary purpose of liquidity ratios? ›
A liquidity ratio is used to determine a company's ability to pay its short-term debt obligations. The three main liquidity ratios are the current ratio, quick ratio, and cash ratio. When analyzing a company, investors and creditors want to see a company with liquidity ratios above 1.0.
What is liquidity and why is it important? ›
Liquidity is how easily an asset can be converted into cash and be spent. Every asset and investment requires finding a market if you decide to sell it—whether it's the stock market, where selling a stock or mutual fund is usually fast and simple, or the more complicated world of finding a buyer for real estate.
How to improve liquidity ratio? ›
Here are five ways to improve your liquidity ratio if it's on the low side:
- Control overhead expenses. ...
- Sell unnecessary assets. ...
- Change your payment cycle. ...
- Look into a line of credit. ...
- Revisit your debt obligations.
It is calculated by dividing the total current assets by total current liabilities. The quick ratio, also known as the acid ratio, determines the ability of the company to pay off its short-term liabilities with the most liquid assets, meaning that inventory is excluded.
What is a good current liquidity ratio? ›
The current ratio measures a company's capacity to pay its short-term liabilities due in one year. The current ratio weighs a company's current assets against its current liabilities. A good current ratio is typically considered to be anywhere between 1.5 and 3.
But it's also important to remember that if your liquidity ratio is too high, it may indicate that you're keeping too much cash on hand and aren't allocating your capital effectively. Instead, you could use that cash to fund growth initiatives or investments, which will be more profitable in the long run.
How to find liquidity? ›
Types of liquidity ratios
- Current Ratio = Current Assets / Current Liabilities.
- Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities.
- Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.
- Net Working Capital = Current Assets – Current Liabilities.
Interpretation of the Cash Ratio
Although there is no ideal figure, a ratio of not lower than 0.5 to 1 is usually preferred. The cash ratio figure provides the most conservative insight into a company's liquidity since only cash and cash equivalents are taken into consideration.
What is the formula for liquid liquid ratio? ›
The flow rate formula is the velocity of the fluid multiplied by the area of the cross-section: Q = v × A . The unit for the volumetric flow rate Q is m 3 / s .
How to find quick assets? ›
Quick assets = (cash + cash equivalents + short-term investments + accounts receivable ) / (current liabilities)
How to find working capital? ›
The working capital calculation is:
- Working Capital = Current Assets - Current Liabilities.
- Net working capital = current assets (minus cash) - current liabilities (minus debt)
- Net working capital = accounts receivable + inventory - accounts payable.
Liquidity ratio = Cash (near cash) / monthly expenses
The ratio helps a person to be aware of his/her financial liquidity. It's important to maintain a fixed level of liquidity to ward off unexpected financial hardships.
Why is the liquidity ratio so important and how can it be used to help insure the success of your business? ›
Liquidity is a measure of a company's ability to pay off its short-term liabilities—those that will come due in less than a year. It's usually shown as a ratio or a percentage of what the company owes against what it owns. These measures can give you a glimpse into the financial health of the business.
Why is liquidity and solvency ratio important? ›
The liquidity ratio focuses on the company's ability to clear its short term debt obligations. The solvency ratio focuses on the company's ability to clear its long term debt obligations. The liquidity ratio will help the stakeholders analyse the firm's ability to convert their assets into cash without much hassle.
What is better liquidity ratios? ›
Typically, a liquidity ratio over 1 is considered good. To improve a company's liquidity ratio in the long term, it also helps to take a look at accounts receivable and payable. Ensure that you're invoicing customers as quickly as possible, and they're paying on time.
