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Having a strong understanding of your company’s accounting liquidity is vital. To do that, you’ll need to explore liquidity ratios in a little more detail. But what is a liquidity ratio? And furthermore, what’s a good liquidity ratio to aim for? Find out everything you need to know about liquidity ratio formulas, starting with our liquidity ratio definition.
Liquidity ratio definition
So, what is a liquidity ratio? Essentially, a liquidity ratio is a financial metric you can use to measure a business’s ability to pay off their debts when they’re due. In other words, it tells us whether a company’s current assets are enough to cover their liabilities. Although it’s always a good idea for business owners to have a robust understanding of their company’s liquidity, accounting liquidity ratios are primarily used by creditors/lenders to determine whether to extend credit.
Most common liquidity ratio formulas
Now, let’s explore some of the most widely used liquidity ratio formulas:
Current ratio – Sometimes referred to as the working capital ratio, the current ratio measures your business’s current assets against its current liabilities. Because it’s focused on current assets, you’ll need to include relatively illiquid assets that may not be easy to convert into cash, such as real estate or inventory. You can work out the current ratio using the following liquidity ratio formula:
Quick ratio – Also known as the acid-test ratio, the quick ratio looks at whether you’re able to pay off your liabilities with quick assets, which are assets that you can convert to cash within the space of 90 days. As such, the quick ratio is a great indicator of short-term liquidity. You can use the following liquidity ratio formula for your calculations:
Cash ratio – Finally, there’s the cash ratio, which looks at your company’s ability to pay off your current liabilities with cash or cash equivalents (i.e., marketable securities, treasury bills, etc.). This means that all other assets, including accounts receivable, inventory, and prepaid expenses, shouldn’t be included in your calculation. The following liquidity ratio formula can help you to determine your business’s cash ratio.
There are a couple of other liquidity ratio formulas that you may encounter, such as the operating cash flow ratio, but generally speaking, the current, quick, and cash ratios are the only accounting liquidity ratios that you’ll need to get to grips with.
What is a good liquidity ratio?
Now that you know a little more about the most common liquidity ratio formulas used in business let’s think a bit more about what sort of results you’ll want to see. In short, a “good” liquidity ratio is anything higher than 1. Having said that, a liquidity ratio of 1 is unlikely to prove that your business is worthy of investment. Generally speaking, creditors and investors will look for an accounting liquidity ratio of around 2 or 3.
A higher liquidity ratio means that your business has a more significant margin of safety with regard to your ability to pay off debt obligations. But it’s also important to remember that if your liquidity ratio is too high, it may indicate that you’re keeping too much cash on hand and aren’t allocating your capital effectively. Instead, you could use that cash to fund growth initiatives or investments, which will be more profitable in the long run.
Furthermore, you need to remember that when looked at in isolation, your accounting liquidity ratio may not be giving you the whole story. Instead, you need to look at your liquidity ratio as part of a trend. If a firm has a particularly volatile liquidity ratio, it may indicate that the business has a certain level of operational risk and may be experiencing financial instability.
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