What is liquidity ratio and how does it work?
A liquidity ratio is a measurement which is used to indicate whether a debtor will be able to pay their short-term debt off with the cash they have readily available, or whether they’ll need to raise additional capital to cover the amount. This kind of metric can also show how swiftly the assets held by the debtor can be turned into cash for the debt.
Finance Terms
Key takeaways from this section:
- Liquidity ratios are types of ratios that show a company’s ability to pay off short-term debts from its cash.
- There a number of different liquidity ratios that creditors and debtors use to establish metrics about the liquidity of a business and its coverage of short-term debts.
- Liquidity ratios can give an idea of the financial health of a business, though they’ll rarely tell the whole story. Full analysis is needed to establish a full picture of the state of a company’s finances.
Understanding liquidity ratios
When we talk about liquidity, we’re talking about how quickly or easily a company’s assets can be turned into cash without losing their value. The more liquid the assets of a business, the more quickly they can get cash to pay off their debt.
Liquidity ratios are what creditors (and sometimes debtors) use to work out if a company can repay creditors from the total cash they have available. The higher the liquidity ratio is for that company, the more liquid their assets are and the more able they’ll be to pay off short-term debts.
There are a number of different liquidity ratios that can show the status of the debtor – these include:
- Current ratio
- Quick ratio
- Operationcash flow ratio
- Working capital
- Working capital ratio
- Absolute liquid ratio.
When used in conjunction with each other, these metrics can give a comprehensive overview of how likely it is that the debtor can pay of their debt without raising extra capital.
What are the different kinds of liquidity ratios?
The most common liquidity ratio used is thecurrent ratio. The current ratio gives an indication of the company’s ability to pay off current debts using the entirety of the assets the company has available.
The formula for working out the current ratio looks like this:Current Ratio = Current Assets÷Current Liabilities.If the current ratio is higher than 1.00, it means the cash available covers the short-term liabilities.
Another much-used liquidity is thequick ratiooracid test ratio. Unlike the current ratio which takes into account all of the assets of a company, the quick ratio focuses on the business’ quick assets - that is to say, highly liquid assets that can be turned into cash swiftly and without losing too much of their book value.
The formula for this kind of liquidity ratio is:Quick Ratio = Liquid Assets÷ Quick Liabilities.As with the current ratio, a quick ratio of higher than 1.00 means that the full debts can be paid. We’ve also written a full guide on quick ratios to give you a better idea.
What is the difference between a liquidity ratio and a solvency ratio?
The biggest difference between a liquidity ratio and a solvency ratio is the time and length of the debts and obligations in question.
As we have seen, a liquidity ratio deals with short-term or current loans – giving an indication of a business’ ability to deal with those short-term obligations. They show the liquidity of the company’s assets.
Solvency ratios deal with the long-term view, which includes long-term debts and the complete array of financial obligations that a business can have.
What is a good liquidity ratio?
If your liquidity ratio for your business is higher than one, then your company is in good financial shape and will be able to take on financial challenges in the future. The higher the liquidity ratio, the healthier your businesses finances will be.
Anything below one and you should be considering strategies to improve the way your business works to keep yourself financially protected.
What are the three main types of liquidity ratio?
While there are a number of different kinds of liquidity ratio you can calculate for your business, the most common ones are the current ratio, the quick ratio and the cash flow ratio. Using a combination of these three liquidity ratios can provide a clear look at the performance of your business from a financial perspective.
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