The financial stability of a company can be tested in many ways.
One of the quickest ways to see just how well a company is performing is to use financial ratios. In this lesson, you will learn what liquidity ratios are, how to calculate them, and how to interpret them.
Liquidity Ratio Defined
In accounting, the term liquidity is defined as the ability of a company to meet its financial obligations as they come due. The liquidity ratio, then, is a computation that is used to measure a company’s ability to pay its short-term debts. There are three common calculations that fall under the category of liquidity ratios. The current ratio is the most liberal of the three. It is followed by the acid ratio, and the cash ratio.
These three ratios are often grouped together by financial analysts when attempting to accurately measure the liquidity of a company.
The current ratio indicates a company’s ability to pay its current liabilities from its current assets. This ratio is one used to quickly measure the liquidity of a company.
The formula for the current ratio is:Current Ratio = Current Assets ÷ Current LiabilitiesNote that this formula considers all current assets and current liabilities. Current assets are those assets that are expected to turn into cash within one year. Examples of current assets are cash, accounts receivable, and prepaid expenses. Also included in this category are marketable securities such as government bonds and certificates of deposit. Current liabilities are those debts that are expected to be paid or come due within a year. Examples of current liabilities are accounts payable, payroll liabilities, and short-term notes payable.Look at the following example:Company A has the following information listed on its balance sheet:Current Assets = $50,000Current Liabilities = $25,000What is the current ratio for Company A? Again, remember the formula:Current Ratio = Current Assets ÷ Current LiabilitiesSo, ifthe Current Ratio = $50,000 ÷ $25,000, thenthe Current Ratio = 2 or 2 to 1What does this mean? 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.
A current ratio that is better than 1 to 1 is considered good. 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.
The second ratio that we will discuss is the acid ratio.
This ratio is also referred to as the quick ratio. The purpose of this ratio is to measure how well a company can meet its short-term obligations with its most liquid assets. Remember, liquid assets are those that can be quickly turned into cash. Most of the current assets are highly liquid with the exception of inventory, which often takes a longer amount of time to turn into cash.
The formula for calculating the acid ratio is:Acid Ratio = (Cash & Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current LiabilitiesCash 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. Treasury bills and commercial paper.Let’s look back at Company A. If the balance sheet for Company A gave us the following information, what would the acid ratio be?Cash ; Cash Equivalents = $20,000Short-Term Investments = $5,000Accounts Receivable = $10,000Inventory = $15,000Current Liabilities = $25,000The formula, again, is:Acid Ratio = (Cash ; Cash Equivalents + Short-Term Investments + Accounts Receivable) ; Current LiabilitiesSo then,the Acid Ratio = ($20,000 + $5,000 + $10,000) ; $25,000 and sothe Acid Ratio = $35,000 ; $25,000 which means,the Acid Ratio = 1.
4 to 1Interpreting the acid ratio for Company A shows us that for every $1 in liabilities, the company has $1.40 in liquid current assets. This ratio, like the current ratio, shows that Company A is in excellent financial position because it not only has enough assets to pay its short-term liabilities, but it also has money left over.
The final liquidity ratio that we will discuss is the cash ratio. Of the three ratio calculations, the cash ratio is the most stringent measurement of a company’s liquidity.
The cash ratio focuses strictly on the cash and cash equivalents of a company. Accounts receivables, inventory, and prepaid expenses are not as easy to convert to cash as cash equivalents are, thus are not considered for this calculation. The formula for the cash ratio is:Cash Ratio = (Cash + Cash Equivalents) ÷ Current LiabilitiesLook at the balance sheet information for Company A again. What is the cash ratio for this company?If the Cash Ratio= $20,000 ÷ $25,000, thenthe Cash Ratio = 0.80Notice 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. Once again, analysts would say that Company A is financially sound.
Financial analysts, potential investors, and potential creditors all use liquidity ratios for the same purpose.
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.
Liquidity – the ability of a company to meet its financial obligations as they come due Liquidity ratio – a computation that is used to measure a company’s ability to pay its short-term debtsCurrent ratio – measures a company’s ability to pay its current liabilities from its current assetsAcid ratio – also known as quick ratio; measures how well a company can meet its short-term obligations with its most liquid assetsLiquid assets – assets which can be quickly turned into cashCash ratio – measures a company’s ability to pay its current liabilities using only the cash and cash equivalents of the company
After viewing this lesson, you should be able to:
- Name three types of liquidity ratios
- Calculate a company’s liquidity using any one of the three ratios
- Judge the financial soundness of a company based on its liquidity ratios