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 types of liquidity ratios and their importance? ›
Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding. Liquidity ratios determine a company's ability to cover short-term obligations and cash flows, while solvency ratios are concerned with a longer-term ability to pay ongoing debts.
What factors affect liquidity ratios? ›
Some industries may naturally have higher liquidity ratios, while others may have lower ratios. Factors such as inventory turnover, credit terms with customers and suppliers, and the level of short-term liabilities influence industry-specific liquidity benchmarks.
What is the purpose of calculating 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.
What is the formula for liquidity? ›
It is calculated by dividing total current assets by total current liabilities. A higher ratio indicates the company has enough liquid assets to cover its short-term debts. In comparison, a low ratio suggests that the company may not have enough cash or other liquid assets to cover its immediate liabilities.
Why is liquidity important? ›
Liquidity provides financial flexibility. Having enough cash or easily tradable assets allows individuals and companies to respond quickly to unexpected expenses, emergencies or business opportunities. It allows them to balance their finances without being forced to sell long-term assets on unfavourable terms.
What ratios are useful in assessing liquidity? ›
Examples of liquidity ratios
Also called the working capital ratio, it is calculated by dividing your current assets—such as cash, inventory and receivables—by your current liabilities, such as line-of-credit balance, payables and the current portion of long-term debts.
What improves liquidity ratio? ›
Liquidity ratios, which measure a firm's capacity to do that, can be improved by paying off liabilities, cutting back on costs, using long-term financing, and managing receivables and payables.
What does liquidity depend on? ›
The liquidity of securities depends on the type, risk, demand and market price as well as other factors. Money market funds and CDs, for example, are highly liquid. And highly liquid securities are often described as “marketable securities.”
How is liquidity related to risk? ›
Liquidity risk is the risk of loss resulting from the inability to meet payment obligations in full and on time when they become due. Liquidity risk is inherent to the Bank's business and results from the mismatch in maturities between assets and liabilities.
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.
Generally speaking, a good quick ratio is anything above 1 or 1:1. A ratio of 1:1 would mean the company has the same amount of liquid assets as current liabilities. A higher ratio indicates the company could pay off current liabilities several times over.
What is a good profitability ratio? ›
In general, the higher the percentage, the better. However, every type of profitability ratio varies. For example, a good operating margin ratio is 1.5%, plus, whilst a good net margin ratio is 5%, and 10% would be considered excellent.
Why are liquidity ratios important to investors? ›
Importance of liquidity ratio
Helps in determining the financial stability of a business: The liquidity ratio as a metric in financial calculation helps determine how stable the finances of a business are, indicating how capable a business is in meeting its short-term financial obligations.
What is the rule of liquidity? ›
A fund is required to determine a minimum percentage of its net assets that must be invested in highly liquid investments, defined as cash or investments that are reasonably expected to be converted to cash within three business days without significantly changing the market value of the investment.
Why would a person want assets with liquidity? ›
Liquid assets, however, can be easily and quickly sold for their full value and with little cost. Companies also must hold enough liquid assets to cover their short-term obligations like bills or payroll; otherwise, they could face a liquidity crisis, which could lead to bankruptcy.
How many types of liquidity are there? ›
The three main types are central bank liquidity, market liquidity and funding liquidity. We analyse the properties and empirical behaviour of each liquidity (risk) type. We also present measures of liquidity risk and discuss the relation between liquidity and liquidity risk.
Why is the quick ratio important? ›
Why Is the Quick Ratio Important? The quick ratio communicates how well a company will be able to pay its short-term debts using only the most liquid of assets. The ratio is important because it signals to internal management and external investors whether the company will run out of cash.
What are the three major liquidity ratios used in evaluating financial statements? ›
As an investor, it helps to know how Wall Street analysts compute and assess three common liquidity ratios—current, quick, and cash—on a regular basis. These ratios can help you: Assess how well a company manages its cash.
Why are efficiency ratios important? ›
The efficiency ratio is typically used to analyze how well a company uses its assets and liabilities internally. An efficiency ratio can calculate the turnover of receivables, the repayment of liabilities, the quantity and usage of equity, and the general use of inventory and machinery.
