Liquidity Ratios Explained: 4 Common Liquidity Ratios

The liquidity ratio is a financial ratio that reveals whether a company has enough working capital to pay down its short-term debt. Working capital comes from current assets—notably cash and cash equivalents (such as marketable securities that can be sold to create cash flow).

The simplest way to calculate a company's liquidity ratio is to divide its current assets by its current liabilities. Often financial analysts focus squarely on short-term obligations; longer-term financial obligations are designed to be paid back over many years and do not necessarily reveal financial health.

A company's liquidity ratio usually takes one of four forms.

1. 1. Current ratio: Calculating the current ratio of a company or individual is the simplest and most common way of measuring liquidity. The current ratio looks at a company's total current assets—cash assets and otherwise—against their total current liabilities like debt obligations. The current ratio formula is: Current Ratio = Current Assets / Current Liabilities.
2. 2. Quick ratio: The quick ratio takes higher liquidity assets into account than the current ratio does. The quick ratio considers a company's cash and cash equivalents, short-term investments, and accounts payable against its current liabilities. Use this formula to calculate a party’s quick ratio: Quick Ratio = (Cash and Cash Equivalents, Accounts Payable, Short-Term Investments) / Current Liabilities.
3. 3. Acid-test ratio: The acid-test ratio is a variation on the quick ratio, subtracting inventories and prepaid costs from current assets. Use this formula to calculate the acid-test ratio: Acid-Test Ratio = (Current Assets - Inventories - Pre-paid costs) / Current Liabilities.
4. 4. Cash ratio: The cash ratio is the strictest means of measuring a company's liquidity because it only accounts for the highest liquidity assets, which are cash and liquid stocks. Use this formula to calculate cash ratio: Cash Ratio = (Cash and Cash Equivalents) / Current Liabilities.

All four of these common liquidity ratios focus on short-term liabilities (such as accounts payable and regular employee salaries) rather than total liabilities. Long-term debt is designed to be paid back over many years, and in some cases, a business may make more money by not paying off its long-term debt all at once. This is particularly true in times of low interest rates.

A liquidity ratio can reveal one of three financial indicators.

• Liquidity ratio of one: If a company's current assets equal its current liabilities, then it will have a liquidity ratio of one. In other words, its current assets could pay for one hundred percent of its current short-term debt.
• Liquidity ratio of less than one: If a company’s liquidity ratio is less than one, the company does not have enough cash (or cash equivalents) to meet its short-term debt obligations. For instance, a liquidity ratio of 0.75 means that the company only has enough cash on hand to pay 75 percent of its short-term liabilities. This could foretell a liquidity crisis.
• Liquidity ratio over one: If a business's current ratio measures greater than one, it has more than enough liquid assets to cover the short-term debts on its balance sheet. For instance, a financial statement that shows a liquidity ratio of two suggests that the company has enough cash assets (or the equivalent) to pay its liabilities two times over.

Liquidity ratios reveal numerous insights about a company.

1. 1. Solvency: Liquidity ratios are essentially solvency ratios. If a company does not have enough liquid assets to quickly pay off short-term debt and liabilities, it may teeter on the edge of bankruptcy.
2. 2. Profitability: While some startups may endure heavy debt as part of their early existence, a well-established business needs to be profitable to survive. If a company cannot manage to have a steady cash flow many years into its existence, it may not be designed for profitability.
3. 3. Billing: Some companies struggle to maintain a reasonable amount of cash on hand because their customers don't pay their bills on time. The Days Sales Outstanding (DSO) ratio compares the balance of accounts receivable to the revenue a company makes in a day. Accounts receivable does not factor into all liquidity ratios, but it is a key component of the quick ratio, which is favored by some accounting managers and investment bankers.

All investments and investment strategies entail inherent risks and introduce the potential for financial loss or the depreciation of assets. The information presented in this article is for educational, informational, and referential purposes only. Consult a professional investment advisor before making any financial commitments.

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