Liquidity ratio
What is a liquidity ratio?
A liquidity ratio is a financial metric used to assess a company’s ability to meet its short-term obligations using its most liquid assets. These ratios help stakeholders determine whether a business has enough resources on hand to pay off its current debts as they come due, providing critical insight into financial health and operational stability.
Key takeaways
Short-term solvency indicator
Liquidity ratios measure how easily a company can convert assets into cash to cover immediate liabilities, reflecting its short-term financial strength.
Common liquidity ratios
- Current ratio = Current assets / Current liabilities
- Quick ratio (Acid-test ratio) = (Current assets – inventories) / Current liabilities
- Cash ratio = Cash and cash equivalents / Current liabilities
Industry benchmarking
Ideal liquidity ratio values vary by industry, but generally, a ratio above 1 indicates that a company can cover its short-term obligations.
Early warning signal
Regular monitoring of liquidity ratios helps businesses spot potential cash flow problems before they escalate.
Why do liquidity ratios matter?
Strong liquidity ratios provide companies with financial stability by assuring creditors and investors that short-term commitments can be met, thus reducing default risk. These ratios are key indicators of creditworthiness, as banks and suppliers often rely on them to decide whether to extend credit or favorable payment terms. Additionally, companies with healthy liquidity enjoy greater operational flexibility, enabling them to seize new opportunities or handle unexpected expenses without financial strain.
The liquidity ratio calculation process
Gather financial data
Use the company’s balance sheet to obtain current assets, current liabilities, and cash equivalents.
Apply the formulas
- Current ratio: Divide total current assets by total current liabilities.
- Quick ratio: Subtract inventories from current assets, then divide by current liabilities.
- Cash ratio: Divide cash and cash equivalents by current liabilities.
Interpret the results
Compare the ratios to industry benchmarks and historical trends to assess financial health.
Impact on business performance
Solvency: High ratios indicate a strong ability to pay short-term debts.
Credit access: Healthy ratios improve chances of securing loans or supplier credit.
Risk management: Low ratios warn of potential liquidity crises or insolvency.
Investor confidence: Transparent liquidity metrics build trust with shareholders.
Example calculation
Scenario:
- Current assets: ₹4,00,000
- Inventories: ₹1,00,000
- Cash and cash equivalents: ₹50,000
- Current liabilities: ₹2,00,000
Current ratio:
₹4,00,000 / ₹2,00,000 = 2.0
Quick ratio:
(₹4,00,000 – ₹1,00,000) / ₹2,00,000 = 1.5
Cash ratio:
₹50,000 / ₹2,00,000 = 0.25
Disclaimer: The information provided in this business glossary is for educational purposes only and should not be considered as financial advice. Always consult with qualified financial professionals before making investment decisions.
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Table of Contents
Liquidity ratio
What is a liquidity ratio?
A liquidity ratio is a financial metric used to assess a company’s ability to meet its short-term obligations using its most liquid assets. These ratios help stakeholders determine whether a business has enough resources on hand to pay off its current debts as they come due, providing critical insight into financial health and operational stability.
Key takeaways
Short-term solvency indicator
Liquidity ratios measure how easily a company can convert assets into cash to cover immediate liabilities, reflecting its short-term financial strength.
Common liquidity ratios
- Current ratio = Current assets / Current liabilities
- Quick ratio (Acid-test ratio) = (Current assets – inventories) / Current liabilities
- Cash ratio = Cash and cash equivalents / Current liabilities
Industry benchmarking
Ideal liquidity ratio values vary by industry, but generally, a ratio above 1 indicates that a company can cover its short-term obligations.
Early warning signal
Regular monitoring of liquidity ratios helps businesses spot potential cash flow problems before they escalate.
Why do liquidity ratios matter?
Strong liquidity ratios provide companies with financial stability by assuring creditors and investors that short-term commitments can be met, thus reducing default risk. These ratios are key indicators of creditworthiness, as banks and suppliers often rely on them to decide whether to extend credit or favorable payment terms. Additionally, companies with healthy liquidity enjoy greater operational flexibility, enabling them to seize new opportunities or handle unexpected expenses without financial strain.
The liquidity ratio calculation process
Gather financial data
Use the company’s balance sheet to obtain current assets, current liabilities, and cash equivalents.
Apply the formulas
- Current ratio: Divide total current assets by total current liabilities.
- Quick ratio: Subtract inventories from current assets, then divide by current liabilities.
- Cash ratio: Divide cash and cash equivalents by current liabilities.
Interpret the results
Compare the ratios to industry benchmarks and historical trends to assess financial health.
Impact on business performance
Solvency: High ratios indicate a strong ability to pay short-term debts.
Credit access: Healthy ratios improve chances of securing loans or supplier credit.
Risk management: Low ratios warn of potential liquidity crises or insolvency.
Investor confidence: Transparent liquidity metrics build trust with shareholders.
Example calculation
Scenario:
- Current assets: ₹4,00,000
- Inventories: ₹1,00,000
- Cash and cash equivalents: ₹50,000
- Current liabilities: ₹2,00,000
Current ratio:
₹4,00,000 / ₹2,00,000 = 2.0
Quick ratio:
(₹4,00,000 – ₹1,00,000) / ₹2,00,000 = 1.5
Cash ratio:
₹50,000 / ₹2,00,000 = 0.25
Disclaimer: The information provided in this business glossary is for educational purposes only and should not be considered as financial advice. Always consult with qualified financial professionals before making investment decisions.
Get paid globally. Keep more of it.
No FX markups. No GST. Funds in 1 day.