Liquidity ratio enables the investors to analyse the ability of a company to pay off its current liabilities as and when they become due and also the long term liabilities whenever they become current liabilities. This ratio is important as it keeps a check on the cash flow levels of a company and its ability to turn other assets into cash to pay off its liabilities and any other current obligations.
Liquidity ratio also takes a look at how well a company will be able to convert assets into cash. Assets like account receivable, stocks, trading securities, inventory are relatively easy for many companies to convert into cash in the short term.
Some of the common Liquidity ratios are:
- Quick Ratio / Acid Test / Liquid Ratio: It takes into account of all those assets which can be converted into cash in the next 90 days. Such assets are also known as Quick Assets.
Quick Ratio = (Cash + Cash Equivalents + Short Term Investments + Current Receivables) / Current Liabilities
Quick ratio of 1:1 is considered to be normal. It indicates that for each rupee of current liabilities, company has matching liquid assets.
- Current Ratio / Working Capital Ratio: Unlike Quick Ratio, Current Ratio takes into account all the current assets forming part of the company’s balance sheet in order to determine the company’s ability to pay off its current debts and liabilities. Primarily, inventory and loans and advances are added to the numerator of the Quick Ratio.
Current Ratio = Current Assets / Current Liabilities
Current ratio of 2:1 is considered to be good. Lower number indicates lower current assets in relation to each unit of current liabilities.