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What is Liquidity Ratio?

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What is Liquidity Ratio?

The ratios that determine the capability of the organization to overcome the short-term debt obligations and dues are known as the liquidity ratios. The liquidity ratios are the outcomes of the cash that needs to be distributed and other liquid assets for the short period of time that the organization has borrowed and the current liabilities. These reflect the number of times the short term debt obligations are covered by the cash and other cash equivalents. The more is the liquidity ratio, the more will be the capability of the company to pay the liabilities and other obligations. If the liquidity ratio results in 1 or more than that, it means that the company is going through a good financial state. On the other hand, if the ratio is less than 1, the company is likely to face extreme difficulties.

Liquidity ratio simply works as an indicator of whether the current assets of the company will be enough in order to face the obligations of the organization. If used with the purpose of making a comparison, the liquidity ratios are considered to be very useful. The liquidity ratio analysis is less efficient and effective at the time of comparing the businesses of different sizes in the different geographical areas. The liquidity ratio works at its best when a comparison needs to be made among the company and its competitors to find out the strategic position of the company.

Why consider Liquidity Ratio?

The credibility and the credit rating of the company are affected by the Liquidity Ratio. If the irregularity in the repayment of the liability for a shorter period of time occurs, then it will simply lead to bankruptcy. Therefore, liquidity ratio plays a significant role to find out the financial stability and the credit ratings of any business organization.

Types of Liquidity Ratios

  1. Current Ratio

In order to analyze, if the company is financially strong or not, the current ratio is used. 2:1 is considered to be the ideal ratio, but sometimes, it may change and depend upon the particular industry.

Formula: Current Assets/Current Liability

Where,

Stock, debtors, cash and bank, receivables, other current assets – fall under the category of Current Assets.

The creditor, short-term loan, bank overdraft, expenses unsettled, other current liabilities – fall under the category of Current Liability.

  1. Quick Ratio

The quick ratio is also known as the acid test ratio to determine the liquidity of the company. This is considered to be the conventional ratio in comparison to the current ratio. The quick assets can be calculated by making adjustments i.e. eradicating the non-cash assets from the current assets. 1:1 is the standard ratio for this.

Formula: Quick Assets/ Current Liability

Where,

Quick Assets= Current Assets- Inventory- Prepaid Expenses. 

  1. Absolute Liquidity Ratio

The total liquidity available for the company is measured by the absolute liquidity ratio. The short-term liquidity is measured by this type of ratio. The short-term liquidity includes – cash, marketable securities, and current investment.

Formula: Cash + Marketable Securities/ Current Liability.

  1. Basic Defense Ratio

The number of days a company has covered its cash expenses without taking any help from the additional or any extra financing institutions or any other sources is stated by the basic defense ratio.

Formula: (Cash+ Receivables+ Marketable Securities) / (Operating Expenses+ Interest+ Taxes) / 365.

Related article: Efficiency Ratios

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