Liquidity Ratios
Liquidity ratio is a class of financial metrics used to measure a company's ability to pay off its short-term liabilities, usually due within a year. Another way to think about liquidity ratio is how easily and efficiently a company can convert its assets into cash so it can service its short-term debts.
A higher liquidity ratio suggests that the company is able to cover its short-term obligation. A low liquidity ratio would suggest otherwise. Liquidity ratios should not be used in isolation and are best when combined with other factors.
When used as internal analysis, liquidity ratios can be used by comparing prior periods to current operations, assuming the same accounting method is used in that timeframe.
When used as an external analysis, liquidity ratios can be used to compare different companies within an industry. It is important to keep in mind that it may not be effective to compare the liquidity ratios between companies across different industries, sizes, or geographical locations.
The three common liquidity ratios are Current Ratio, Quick Ratio, and cash ratio in the order of least to most conservative.
Current Ratio
Current Ratio measures a company's ability to pay off its current liabilities. This is the least conservative liquidity ratio as it includes all current assets. The formula for Current Ratio is:
Current Ratio = CA / CL
CA = Current Assets CL = Current Liabilities
Quick Ratio
Quick Ratio measures a company's ability to meet its short-term obligations with its most liquid assets. This means excluding inventory from current assets because inventory is les liquid than cash. Quick Ratio is also known as the Acid-Test Ratio. The formula for Quick Ratio is:
Quick Ratio = (C + MS + AR) / CL
Where C = Cash or Cash Equivalents, MS = Marketable Securities, AR = Accounts Receivable, CL = Current Liabilities
Another way to look at Quick Ratio is:
Quick Ratio = (CA - I - E_prepaid) / CL
Where CA = Current Assets, I = Inventory, E_prepaid = Prepaid Expenses, CL = Current Liabilities
Cash Ratio
Cash Ratio is the most conservative liquidity ratio and considers only cash and cash equivalents in relation to current liabilities. The formula for Cash Ratio is:
Cash Ratio = C / CL
Where C = Cash or Cash Equivalents, CL = Current Liabilities