Liquidity Ratio Types, Formulas & Examples of Liquidity Ratio

Cash is generally the most liquid asset because it’s available at the touch of a few buttons on an ATM pad or a digital app — or sometimes in your wallet. The better a business’s liquidity ratio, the more attractive it will be to lenders and investors, both of which can be extremely important for growth. Creditors analyze liquidity ratios when deciding whether or not they should extend credit to a company. They want to be sure that the company they lend to has the ability to pay them back. The current ratio of the company is 2.5 means that the company’s current assets are 2.5 times of liabilities. It means the company’s liquidity position is satisfactory, and it can meet its current liabilities in time and when it becomes due.

Companies most widely use the current assets ratio to assess the concern’s liquidity position or short-term financial position. While Liquidity Ratios measure a company’s ability to pay off short-term obligations (accounts payable), solvency ratios measure a company’s ability to pay off long-term obligations (debt). One might think that a company should aim https://personal-accounting.org/ for the highest possible liquidity ratios. This means that the company always has sufficient current assets available to meet its short-term liabilities. Any hint of financial instability may disqualify a company from obtaining loans. Liquidity ratios measure how quickly assets can be turned into cash in order to pay the company’s short-term obligations.

They provide a snapshot of your company’s short-term performance and potential risks that creditors/lenders must consider before extending credit. By correctly calculating liquidity ratio formulas, you can better assess whether or not your current assets are enough to cover your liabilities. Liquidity Ratios are essential for evaluating a company’s ability to fulfill short-term financial obligations and offer insights into its fiscal health. By examining the liquid assets to current liabilities ratio, businesses can determine if they have adequate resources to manage immediate expenses without affecting cash flow.

In contrast to liquidity ratios, solvency ratios measure a company’s ability to meet its total financial obligations and long-term debts. Solvency relates to a company’s overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current or short-term financial accounts. The liquidity coverage ratio requires the banks to hold a sufficient amount of high-quality liquid assets to fund cash outflows for 30 days.

1. If the payment is in cash then current assets will be reduced whereas current liabilities will remain at the same figure.
2. This information is useful to compare the company’s strategic positioning to its competitors when establishing benchmark goals.
3. It shows the liquidity levels, i.e. how many of their assets can be quickly converted to cash to pay of their obligations when they become due.
4. Other factors, such as the state of the economy, industry norms, and the company’s prospects, should also be considered.
5. Absolute liquid ratio extends the
   logic further and eliminates accounts receivable (sundry debtors and bills
   receivables) also.

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They are the assets that are most readily available to a company to pay short-term obligations. The receipt of cash will increase cash or bank balance while sundry debtors will be reduced by the same amount. If the payment is in cash then current assets will be reduced whereas current liabilities will remain at the same figure. In the second alternative when purchase is on credit basis, current liabilities will go up while current assets will remain at their previous figure.

Alternatively, external analysis involves comparing the liquidity ratios of one company to another or an entire industry. This information is useful to compare the company’s strategic positioning to its competitors when establishing benchmark goals. Liquidity ratio analysis may not be as effective when looking across industries as various businesses require different financing structures. With liquidity ratios, there is a balance between a company being able to safely cover its bills and improper capital allocation. Capital should be allocated in the best way to increase the value of the firm for shareholders.

Solved Example on Liquidity Ratios

The debt-to-equity ratio is the most common solvency ratio used to determine a company’s long-term financial health. This measures the proportion of total liabilities (current and long-term debt) to total equity in the company. A higher debt-to-equity ratio indicates that more of the company’s assets are funded by creditors than shareholders, which can be risky. The company’s current ratio of 0.4 indicates an inadequate degree of liquidity, with only $0.40 of current assets available to cover every $1 of current liabilities. The quick ratio suggests an even more dire liquidity position, with only $0.20 of liquid assets for every $1 of current liabilities.

Liquidity Ratio vs. Solvency Ratio

If there are continuous defaults in repayment of a short-term liability then this will lead to bankruptcy. Hence this ratio plays important role in the financial stability of any company and credit ratings. This is to ensure that the company can cover all its liabilities without having to liquidate assets from inventories. If the current ratio were only 100%, this would mean that the company can just about service its liabilities with its current assets.

What is a Liquidity Ratio?

In the same manner, prepaid expenses are also excluded from the list of liquid assets because they are not expected to be converted into cash. Some time bank overdraft is not included in current liabilities, on the argument that bank overdraft is generally permanent way of financing and is not subject to be called on demand. Absolute liquid ratio extends the
logic further and eliminates accounts receivable (sundry debtors and bills
receivables) also. Though receivables are more liquid as comparable to inventory
but still there may be doubts considering their time and amount of realization. Therefore, absolute liquidity ratio relates cash, bank and marketable securities
to the current liabilities.

Liquidity coverage ratio is similar to liquidity ratios as it is also a measure of the company’s ability to meet its short-term financial obligations. Statutory Liquidity Ratio is the ratio of liquid assets to Net Demand and Time Liabilities (NDTL). As a business owner, understanding your company’s financial health is essential for success. One key metric to measure this is liquidity ratios, which provide insight into whether or not a company has enough current assets to cover its liabilities. Creditors and lenders can assess the risk of extending credit by analyzing liquidity ratios.

Clear can also help you in getting your business registered for Goods & Services Tax Law. Just upload your form 16, claim your deductions and get your acknowledgment absolute liquid ratio number online. You can efile income tax return on your income from salary, house property, capital gains, business & profession and income from other sources.

This article guides you about how to calculate absolute liquid ratio or cash ratio in test of liquidity. Let’s use a couple of these liquidity ratios to demonstrate their effectiveness in assessing a company’s financial condition. The solvency ratio is calculated by dividing a company’s net income and depreciation by its short-term and long-term liabilities. This indicates whether a company’s net income can cover its total liabilities.