What are Liquidity Ratios?
Liquidity Ratios are used to assess a company’s capacity to fulfil its short-term obligations. They compare short-term responsibilities to short-term (or current) resources available to fulfil these obligations. These ratios provide valuable insight into the firm’s current cash solvency and ability to remain solvent in the face of hardship.
Internal liquidity ratio analysis, for example, necessitates the use of several accounting periods that are presented using the same accounting standards. Analysts can track changes in the firm by comparing historical periods to present operations. A greater liquidity ratio, in general, indicates that a corporation is more liquid and has better coverage of existing loans.
External analysis, on the other hand, involves comparing the liquidity ratios of one business to another or an entire industry. When creating benchmark targets, this information may be used to compare the company’s strategic posture to that of its rivals. When examining across sectors, liquidity ratio research may not be as helpful since different firms demand different funding models. Liquidity ratio analysis is less useful when comparing enterprises of varying sizes and geographical regions.
Types of Liquidity Ratios
Following are the types of liquidity ratios:
Current assets minus current liabilities It demonstrates a company’s capacity to meet its existing liabilities with current assets. The higher the current ratio, the greater the firm’s ability to pay its bills; however, the ratio must be regarded as a crude measure because it does not consider the liquidity of the separate components of current assets. A firm whose current assets are primarily cash and non-overdue receivables is generally regarded as more liquid than a firm whose current assets are primarily inventories.
Current Ratio Formula:
Current ratio= Current Assets / Current Liabilities
The normal ratio for this is 2:1. Current assets should be worth twice as much as current obligations. It should be emphasized, however, that an excessively high ratio may imply that capital is not being employed effectively and efficiently. A scenario like this necessitates financial reform.
This is also known as the acid-test ratio. In this case, inventory and pre-paid costs are omitted from the category of current assets. Only cash, marketable securities, and receivables (known as Quick Assets) are taken into account. The normal Quick Ratio is 1:1, which means that quick assets should equal current liabilities. It should be noted that the current ratio assesses “overall liquidity,” but the quick ratio assesses “immediate liquidity.”
Quick Ratio Formula:
Quick Ratio = Acid Test Ratio = Current assets – Inventories/ Current Liabilities
In analyzing liquidity, this ratio supports the current rate. This ratio is comparable to the current ratio, except it excludes inventories. Presumably, the numerator is the least liquid component of current assets. In regard to current liabilities, the ratio focuses particularly on the more liquid current assets, such as cash, marketable securities, and receivables. As a result, this ratio gives a more comprehensive indicator of liquidity than the current ratio.
Cash Ratio Formula:
Cash Ratio = Cash Equivalents + Marketable Securities/ Current Liabilities
The cash ratio reflects the firm’s short-term liquidity. A high cash ratio shows that the firm is not making the best use of its cash; cash should be put to work in the company’s activities.
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