What Are the Types of Liquidity Ratios?
There are a variety of ratios that assess your business’s liquidity by comparing liquid assets to short-term liabilities. Among these, the most commonly utilized are the current ratio, quick ratio (often referred to as the acid test ratio), and cash ratio. These metrics evaluate the financial stability of a company by examining its capability to meet immediate debt obligations.
How to Calculate Liquidity Ratios
Current Ratio
The current ratio, often referred to as the working capital ratio, evaluates a company’s capacity to meet its short-term debt commitments using its current assets. Calculating the current ratio is simple and involves the following formula:
Current Ratio = Current Assets / Current Liabilities
For instance, if a business has current assets amounting to $400,000 and current liabilities of $200,000, the current ratio would be 2:1. Current assets include liquid assets that can be converted into cash within one year, such as cash, cash equivalents, accounts receivable, short-term deposits, and marketable securities. On the other hand, current liabilities refer to the business’s financial obligations that are due within a year.
A higher current ratio is typically preferable, with a good range being between 1.2 to 2. This indicates that the business has twice the current assets needed to cover its liabilities. A current ratio below 1 suggests that the company may not have enough liquid assets to meet its short-term liabilities. A ratio of 1:1 indicates that current assets are equal to current liabilities, meaning the business can just cover all of its short-term obligations.
Acid Test Ratio
The acid test ratio, or quick ratio, measures the capability to pay off current liabilities with quick assets. Quick assets are those current assets that can be converted into cash within ninety days and typically exclude supplies, inventory, and prepaid expenses. The acid test ratio is calculated using the following formula:
Acid Test Ratio = (Cash and Cash Equivalents + Current Receivables + Short-Term Investments) / Current Liabilities.
Alternatively, if the balance sheet does not provide a detailed breakdown of current assets, you can use this formula:
Acid Test Ratio = (Total Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
A business with an acid test ratio below one lacks sufficient liquid assets to cover its debts. If the difference between the acid test ratio and the current ratio is significant, it implies that the business relies heavily on inventory. Because inventory values differ across industries, it’s prudent to compare a business’s acid test ratio against the industry average.
Cash Ratio
The cash ratio, also known as the cash-asset ratio, assesses the ratio of cash and cash equivalent assets to total liabilities. This ratio indicates the extent to which readily available funds can pay off current liabilities and is commonly used by lenders and potential creditors to evaluate business liquidity. The formula for the cash ratio is:
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
A cash ratio of 1 means the business has just enough cash and cash equivalents to meet its short-term debts. A ratio below 1 indicates insufficient cash to cover short-term debt, whereas a ratio above 1 implies the business can meet all short-term debt and still have leftover cash. However, a significantly high ratio may also suggest that the business’s cash resources are not being used effectively, as they could be invested in profitable ventures rather than earning minimum interest.
What Is an Example of a Liquidity Ratio?
Let’s consider the following financial information:
| Particulars | Amount |
|—————————- |————|
| Cash and Cash Equivalents | 3000 |
| Short-term Investments | 500 |
| Receivables | 1000 |
| Stock | 4000 |
| Other Current Assets | 200 |
| Total Current Assets | 8700 |
| Accounts Payable | 2000 |
| Outstanding Expenses | 800 |
| Tax Payable | 1000 |
| Deferred Revenue | 900 |
| Total Current Liabilities | 5700 |
- Current Ratio = Total Current Assets / Total Current Liabilities
Current Ratio = 8700 / 5700 = 1.53
- Acid Test Ratio = (Total Current Assets – Stock) / Current Liabilities
Acid Test Ratio = (8700 – 4000) / 5700 = 0.83
- Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
Cash Ratio = 3000 / 5700 = 0.53
The liquidity ratio significantly affects a business’s credit rating and credibility. Higher liquidity ensures a company is better prepared to pay off short-term debts, whereas frequent defaults on these obligations can lead to bankruptcy. Thus, liquidity ratios play an essential role in determining the financial stability and health of a business.
Conclusion
In summary, understanding and calculating liquidity ratios is essential for determining the financial health and stability of a business. The current ratio, acid test ratio, and cash ratio each provide unique insights into a company’s ability to meet its short-term liabilities. A higher ratio generally indicates stronger liquidity, making the business more attractive to investors and creditors.
Conversely, a lower ratio can signal potential financial trouble, warranting a closer examination of the company’s asset management practices. By regularly monitoring these ratios, businesses can make informed decisions to maintain optimal liquidity levels and safeguard against financial distress.
