What is the liquidity ratio
What is the liquidity ratio

Many assets and liabilities exist in a business, company, or organization. But as you all know, not all assets are in cash. Every business wants cash for its everyday activities. That’s why every business wants to know how easily and quickly it can convert its assets into cash. 

The liquidity ratio helps solve this problem. If you want to know more about liquidity ratios, read our blog.

Today in this blog, we will discuss what is the liquidity ratio, type of liquidity ratio, examples, and some importance.

What Is The Liquidity Ratio?

Liquidity ratios are fundamental in forecasting the future cash flows of the business. They are widely used for this purpose and for deciding about financing mixes, investment and capital structures.

The ability of a corporation to meet its short-term obligations is measured using these ratios. By comparing current assets and liabilities, liquidity ratios reveal a company’s capacity to meet its short-term financial obligations.

What Are The Types Of Liquidity Ratios?

(1) Current ratio

It is also known as the working capital ratio, which measures the capability of an organization to meet its short-term obligations that are due within 1 year. The current ratio considers the weight of total current assets and current liabilities. It shows a company’s financial health and how it can maximize the liquidity of its current assets to settle debt and payables.

Current assets include:

  • Cash.
  • Stock.
  • Receivables.
  • Prepaid expenditures.
  • marketable securities.
  • Deposit.

Current liabilities include:

  • Short term loans 
  • Payroll liabilities
  • Outstanding expenses
  • Creditors
  • Other payables 

Current ratio formula:

Current ratio = current assets/ current liabilities

Example:

There is a company ABC Ltd, which is in the furniture business. According to the company’s balance sheet, the total of its current assets equals $6000000, and its current liabilities are $2000000. The current ratio of the company will be calculated in the following method.

Answer:

Current ratio = current assets/ current liabilities 

Current ratio = $600000/$2000,000

                    = 3:1

(2) Quick ratio

The quick ratio, referred to as the acid-test ratio, is a type of liquidity ratio that measures a company’s capacity to rapidly pay off its current liabilities using its near-cash or quick assets.

Quick assets include:

  •  Inventory
  •  cash 
  • cash equivalent
  •  marketable securities
  •  accounts receivable

Quick liabilities include:

  • Interest payable
  •  Income taxes payable
  •  Bills payable
  •  Bank account overdrafts

Quick ratio formula

Quick ratio = liquid assets and quick assets/ current liabilities

What are liquid assets?

Those assets can easily be converted into cash in a short period. Like cash, money market instruments, marketable securities, etc.

Liquid assets = current assets – inventories – prepaid expenses

Example:

ABC Ltd. is a textile-based company. The ABC Ltd are recorded as current assets of $80,000, current liabilities of $50,000, inventories of $25,000 and prepaid expenses of $5,000. The liquid ratio and quick ratio will be calculated in the following manner.

answer:

Liquid assets = current assets – inventories – prepaid expenses

Liquid assets = 80000 – 25000 – 5000 = 50000

Quick ratio = liquid assets and quick assets/ current liabilities

Quick ratio = 50,000/ 50,000 =1:1

(3) Cash ratio

It is a measurement of a company’s liquidity. It particularly calculates the ratio of a company’s total cash and cash equivalents to its current liabilities. The metric evaluates a company’s ability to repay its short-term debt with cash and near cash resources like marketable securities, savings accounts, government treasury securities (T-bills) etc.

Cash assets include:

  •  any cash on hand
  •  cash in the bank and other accounts 
  •  readily marketable securities
  • and other cash-equivalent liquid assets.

Cash ratio formula :

Cash ratio = cash and cash equivalents / current liabilities.

Example:

A company ABC Ltd.’s balance sheet lists the following items

Cash $10,000, cash equivalents $20,000, account receivable $5,000, inventory $30,000, property and equipment $ 50,000, account payable $12,000, short term debt $10,000, long term debt $20,000.

Answer:

Cash ratio = cash and cash equivalents/ current liabilities 

Cash ratio = 10,000 + 20,000/ 12,000+ 10,000 = 1.36

Also read: What is budgeting process?

Importance Of Liquidity Ratio

Now that we know what is the liquidity ratio, let’s know some importance of liquidity ratio

  • The liquidity ratio helps in understanding the availability of cash in a company which determines the short-term financial position of the organization.
  • It also presents how efficiently the company can convert inventories into cash. It shows the way a company operates in the market.
  • The liquidity ratio helps organize the company’s working capital requirement by studying the cash and liquid assets available at a certain time.

Conclusion

The liquidity ratio is a useful financial metric that helps understand an organization’s financial position. It provides the stakeholders with a whole idea of an organization’s operating system and depicts how effectively and efficiently the company sells its goods and services. After reading this article, I hope you understand what is the liquidity ratio and its types. We also discuss some formulas and examples of each type of liquidity ratio. In the end, we see some importance of the liquidity ratio.

FAQs on What is the liquidity ratio

Q1. How is liquidity rate calculated?

Ans. Current Ratio = current assets ÷ current liabilities.
Quick Ratio = (current assets – inventory) ÷ current liabilities.
Cash Ratio = (cash + cash equivalents) ÷ current liabilities.

 Q2. What are the two common liquidity ratios?

Ans.  The two most common liquidity ratios are the,
1) current ratio 
2) quick ratio

Q3. Why is high liquidity beneficial?

Ans.  The ability of a company to fulfill its present liabilities, like debt, without having to borrow money or raise outside capital is referred to as liquidity. Low liquidity suggests the contrary and that a company could soon face bankruptcy, whereas high liquidity indicates that a corporation can easily cover its short-term debts.