A company’s liquidity ratio is its ability to pay off its liabilities. A good liquidity ratio is anything greater than 1. It indicates that the business is in good financial shape and is less likely to experience financial difficulties.
The higher the index, the greater the margin of safety the company has to match its current liabilities. Creditors and lenders often use the liquidity ratio when deciding to lend to a company.
What types of liquidity ratios are there?
Several metrics are available for analysis, all of which compare liquid assets to current liabilities.
The most commonly used solvency ratios are the current ratio, the acid test ratio (also known as the quick ratio) and the cash ratio.
These metrics evaluate a company’s overall health based on its short-term ability to keep up with debt.
How to calculate the liquidity index?
The current ratio, also recognized as the working capital ratio, measures the company’s ability to pay its current liabilities with its present assets.
The formula for calculating the current ratio is as follows:
Current ratio = current assets / current liabilities
So if current assets are $400,000 and present liabilities are $200,000, the current ratio is 2:1.
Current assets are liquid assets that can be converted into cash within a year, such as B. Cash, cash equivalents, trade accounts receivable, short-term deposits and marketable securities. Current liabilities are financial obligations of the company that are due within one year.
A higher current ratio is better for businesses. A good employed capital ratio is between 1.2 and 2, which means the company has two times more working capital than liabilities to cover its debt.
A current ratio below 1 means the company does not have enough cash to cover its current liabilities. A ratio of 1:1 indicates that existing assets equal current liabilities and that the company can only cover all current obligations.
the acid Test or Quick Ratio calculates the ability to pay off short-term liabilities with quick fortune.
Fast assets refer to a company’s current assets that can be converted into cash within ninety days. Excludes consumables, inventory and prepaid expenses.
The formula for calculating the acid test ratio is:
Stress test ratio = (cash and cash equivalents + short-term receivables + short-term investments) / short-term liabilities
If the balance sheet provides a breakdown of working capital, you can calculate the acid test using the formula:
Stress Test Ratio = (Total Current Assets – Inventory – Accruals) / Current Liabilities
Companies with less than one performance test do not have enough cash to pay their debts. If the difference between the endurance test and current ratio is large, the company is currently over-relying on inventory.
Because inventory values vary by industry, it’s a good idea to find an industry average and compare the endurance test ratios for that company to that average.
The liquidity ratio, also acknowledged as the cash ratio is the ratio of cash and cash equivalents to your total liabilities.
The ratio indicates the extent to which the available funds can settle short-term liabilities. Lenders and potential creditors commonly use it to measure company liquidity and how easily you can repay debt.
The formula for scheming the current ratio is as follows:
Current Ratio = (Cash + Cash Equivalent) / Current Liabilities
Insufficient cash is available to pay off short-term debt. If the liquidity ratio is 1, the company has the exact amount of cash and cash equivalents to pay off debt. I doubt the liquidity ratio is less than 1.
If a company’s cash ratio is greater than 1, the company can cover all short-term debt and still has cash left over. However, a higher ratio can also indicate that cash is not being used properly, as it could be invested in profitable assets rather than earning the risk-free rate.
What is a case of a liquidity ratio?
amount of data
Cash and cash equivalents 3000
Short-term investments 500
Other current assets 200
Total current assets 8700
Accounts Payable 2000
Outstanding expenses 800
Tax to pay 1000
Accruals and deferrals 900
Total Current Liabilities 5700
- Current Ratio = Total Current Assets / Total Current Liabilities
Current ratio = 8700 / 5700 = 1.53
- Endurance Test Ratio = (Total Current Assets – Shares) / Current Liabilities
Acid test ratio = 8700 – 4000 / 5700 = 0.83
- Current Ratio = (Cash + Cash Equivalent) / Current Liabilities
Current ratio = 3000 / 57000 = 0.53
The liquidity index influences the creditworthiness and credibility of the company. The more liquid your business is, the better equipped you are to pay off short-term debt.
If, on the other hand, there are persistent defaults on a short-term liability, this can lead to insolvency. Therefore, this ratio plays an important role in evaluating the health and financial stability of the company.