Liquidity Ratio Definition & Meaning


It indicates that the company is in good financial health and is less likely to face financial hardships. Notice that the cash ratio is much smaller than the other two ratios. In analyzing the cash ratio, any ratio greater than 0.5 is considered good. In this case, the cash ratio is 0.8 to 1, meaning that for every $1 in current liabilities, there is $0.80 in current assets. Liquidity ratio expresses a company’s ability to repay short-term creditors out of its total cash.

liquidity ratio definition & meaning

Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. We can draw several conclusions about the financial condition of these two companies from these ratios. Andy Smith is a Certified Financial Planner (CFP®), licensed realtor and educator with over 35 years of diverse financial management experience. He is an expert on personal finance, corporate finance and real estate and has assisted thousands of clients in meeting their financial goals over his career. Adam Hayes is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology.The most widely used solvency ratios are the current ratio, acid test ratio and cash ratio. Cash and cash equivalents refer to such things as cash on hand, checking accounts, savings accounts, and money market accounts. Short-term investments are any investments that will mature within 90 days, such as U.S. The liquidity ratio expresses a company’s ability to repay short-term creditors out of its total cash.

How Does Liquidity Differ From Solvency?

Based on its current ratio, it has $3 of current assets for every dollar of current liabilities. Its quick ratio points to adequate liquidity even after excluding inventories, with $2 in assets that can be converted rapidly to cash for every dollar of current liabilities. The acid test ratio or the quick ratio calculates the ability to pay off current liabilities with quick assets. The intent behind using it is to see if there are sufficient current assets on hand to pay for current liabilities, if the current assets were to be liquidated. Inventory may not be that easy to convert into cash, and so may not be a good indicator of liquidity. Interpreting the acid ratio for Company A shows us that for every $1 in liabilities, the company has $1.40 in liquid current assets.

What does a business’s current ratio tell you about its liquidity?

The current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations or those due within one year. It tells investors and analysts how a company can maximize the current assets on its balance sheet to satisfy its current debt and other payables.The quick ratio suggests an even more dire liquidity position, with only $0.20 of liquid assets for every $1 of current liabilities. The quick ratio is a tougher test of liquidity than the current ratio. It eliminates certain current assets such as inventory and prepaid expenses that may be more difficult to convert to cash.

Shortcomings Of Liquidity Ratios

A current ratio greater than or equal to one indicates that current assets should be able to satisfy near-term obligations. A current ratio of less than one may mean the firm has liquidity issues. In finance, the Acid-test measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. A company with a Quick Ratio of less than 1 cannot pay back its current liabilities. Now that you know a little more about the most common liquidity ratio formulas used in business let’s think a bit more about what sort of results you’ll want to see. Having said that, a liquidity ratio of 1 is unlikely to prove that your business is worthy of investment.

liquidity ratio definition & meaning

Generally speaking, creditors and investors will look for an accounting liquidity ratio of around 2 or 3. However, financial leverage based on its solvency ratios appears quite high. Debt exceeds equity by more than three times, while two-thirds of assets have been financed by debt. Note as well that close to half of non-current assets consist of intangible assets . To summarize, Liquids, Inc. has a comfortable liquidity position, but it has a dangerously high degree of leverage.

What Is A Liquidity Ratio?

The liquidity ratio has an impact on the credit rating as well as the credibility of the business. The more liquid your business is, the better equipped it is to pay off short-term debts. Note that in our example, we will assume that current liabilities only consist ofaccounts payable and other liabilities, with no short-term debt. At year-end, Stick, has cash of $15,000, current accounts receivable of $30,000, merchandise inventory of $40,200, and prepaid expenses totaling $4,300. The Acid Test or Quick Ratio measures the ability of a company to use its assets to retire its current liabilities immediately. Financial leverage, however, appears to be at comfortable levels, with debt at only 25% of equity and only 13% of assets financed by debt. Overall, Solvents, Co. is in a dangerous liquidity situation, but it has a comfortable debt position.Let’s use a couple of these liquidity ratios to demonstrate their effectiveness in assessing a company’s financial condition. Cash ratio, also called cash asset ratio, is the ratio of cash and cash equivalent assets to its total liabilities. There are several ratios available for analysis, all of which compare the liquid assets to the short-term liabilities. The company is only just able to meet its short-term obligations with its current assets.

Liquidity Ratio: Definition, Calculation & Analysis

The solvency ratio is calculated by dividing a company’s net income and depreciation by its short-term and long-term liabilities. This indicates whether a company’s net income can cover itstotal liabilities. Generally, a company with a higher solvency ratio is considered to be a more favorable investment. Liquidity is the ability to convert assets into cash quickly and cheaply. Liquidity ratios are most useful when they are used in comparative form. On the other hand, if there are continuous defaults in repayment of a short-term liability, it can lead to bankruptcy.Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses. If a company’s current ratio is in this range, then it generally indicates good short-term financial strength. If current liabilities exceed current assets , then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets or its short-term financing facilities. In such a situation, firms should consider investing excess capital into middle and long term objectives. Essentially, a liquidity ratio is a financial metric you can use to measure a business’s ability to pay off their debts when they’re due. In other words, it tells us whether a company’s current assets are enough to cover their liabilities.

  • Liquidity Coverage Ratio is a requirement under Basel III whereby banks are required to hold enough high-quality liquid assets to fund cash outflows for 30 days.
  • To summarize, Liquids, Inc. has a comfortable liquidity position, but it has a dangerously high degree of leverage.
  • Liquidity ratio for a business is its ability to pay off its debt obligations.
  • A good current ratio is between 1.2 to 2, which means that the business has 2 times more current assets than liabilities to covers its debts.
  • Financial ratios are used to assess the financial stability of a business or other organization.
  • Note that this formula considers all current assets and current liabilities.

For a firm, this will often include being able to repay interest and principal on debts or long-term leases. Note that Inventory is excluded from the sum of assets in the Quick Ratio, but included in the Current Ratio.Current assets are liquid assets that can be converted to cash within one year such as cash, cash equivalent, accounts receivable, short-term deposits and marketable securities. The current liabilities refer to the business’ financial obligations that are payable within a year. It only measures the ability of a firm’s cash, along with investments that are easily converted into cash, to pay its short-term obligations.

Understanding Liquidity Ratios

Low values for the current or quick ratios indicate that a firm may have difficulty meeting current obligations. If an organization has good long-term prospects, it may be able to borrow against those prospects to meet current obligations. Some types of businesses usually operate with a current ratio less than one.They want to know if a company has enough liquid assets to meet its debt load. Companies that have higher liquidity ratios are able to meet their debt load, and are safer investments. Companies with lower liquidity ratios may very well be in danger of financial ruin. Liquidity ratios are also excellent tools for companies to use when performing company self-evaluations. Knowing the correct way to calculate each ratio and what each ratio means is a vital part of the financial world.Hence, this ratio plays important role in assessing the health and financial stability of the business. These ratios assess the overall health of a business based on its near-term ability to keep up with debt. Show bioRebekiah has taught college accounting and has a master’s in both management and business. Acid Test – a ratio used to determine the liquidity of a business entity. The amount of a company’s working capital is also cited as an indicator of liquidity. Learn more about how you can improve payment processing at your business today.When interpreting the current ratio of Company A, you can see that for every $1 in current liabilities, the company has $2 in current assets. The higher the ratio, the better the financial position of the company. Company A is in sound financial position, and the current ratio of 2 to 1 indicates that they can pay their short-term obligations.