If you needed to pay all your short-term debt obligations in the next 30 days, would your company have enough assets to cover its debts? Accounting liquidity looks at the balance between current assets and liabilities, giving a quick snapshot of financial health. We’ll discuss a few of the most common liquidity ratios below, along with how to calculate them.
What are liquidity ratios?
Cash is the most liquid asset, but accounting liquidity looks at more than simply what you have in your bank account. A liquidity ratio measures how well a company can pay its obligations, or current liabilities, using its current – or liquid – assets. There are three primary ratios used to calculate liquidity:
Each offers a slightly different formula for dividing assets by liabilities. Ideally, the ratio will be above 1:1 because this shows that a company has sufficient current assets to cover its current liabilities. If the ratios are less than 1:1, this shows that a company doesn’t have enough assets to cover its liabilities.
Why are liquidity ratios important?
Working out ratios offers a quick and easy way to see whether your business can satisfy its debts. When ratios are less than 1:1, this means you need to find ways to increase liquidity. In fact, creditors and investors prefer to see liquidity ratios closer to 2:1 or 3:1 rather than 1:1, because this indicates that the company has plenty of room to pay its short-term bills and still have working capital to continue operations.
For creditors, working out ratios helps with decision making. A lender wants to be sure that the business has enough current assets to repay its debts. A lower ratio indicates a higher level of risk. The same holds true for investors, who use liquidity ratios as part of an overall financial analysis. While investors might shy away from companies with low liquidity ratios, they will also be wary of those with sky-high ratios. A liquidity ratio of 9.5, for example, would indicate that the company isn’t using its liquid assets in an efficient way. Rather than reinvesting its liquid assets to foster growth, the company might just be letting its cash languish in an account somewhere.
Types of liquidity ratios
Here are the three most used liquidity ratio formulas.
If you can only pick one calculation, the current ratio meaning is the easiest to understand. To calculate current ratio, simply divide total assets by total liabilities. You can find these figures on the company’s balance sheet. Written out as a formula, here is the current ratio meaning:
Current Ratio = Current Assets / Current Liabilities
Business managers and lenders will generally look for a current ratio above 2:1 at a minimum.
The second option is the quick ratio, also called the acid test. While the current ratio uses all current assets, the quick ratio limits its assets to accounts receivable and cash in the bank. Here’s how to calculate the quick ratio:
Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities
A good quick ratio would be 1.5:1, due to its slightly stricter guidelines.
The third liquidity ratio is the cash ratio, which restricts its current assets to cash and marketable securities. This makes it even stricter than the quick ratio.
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
This provides a good sense of how well a company could pay its debts if it only had access to what’s in its accounts today.
Liquidity and net working capital
Although it’s not a ratio, net working capital also offers businesses a quick and easy way to measure liquidity. To calculate net working capital, use the following formula:
Net Working Capital = Current Assets – Current Liabilities
Ideally, your net working capital should consistently be growing alongside your business. Sales and assets should be increasing, which increases net working capital accordingly. If your working capital is declining, this indicates a lack of liquidity.
Although liquidity alone doesn’t paint the full picture of business health, these liquidity ratio formulas are a good jumping-off point particularly for investors. They tell you just how much a company has on hand to work with using its current accounts alone.
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