In accounting, liquidity refers to the ability of a business to pay its liabilities on time. Current assets and a large amount of cash are evidence of high liquidity levels.
Liquidity ratio is an essential accounting tool that is used to determine the current debt repaying ability of a borrower. It helps to determine if a company can use its current, or liquid, assets to cover its current liabilities.
TYPES OF LIQUIDITY RATIOS :-
There are mainly 3 liquidity ratios which are used commonly –
CURRENT RATIO :
The current ratio is a measure of a company’s ability to pay off the obligations within a period of 1 year. It is also known as working capital ratio . It is calculated as –
Current Ratio = Current Assets/ Current Liabilities
Here the current assets include cash, stock, receivables, prepaid expenditures, marketable securities, deposits, etc. And, current liabilities include short-term loans, outstanding expenses, creditors, various other payables, etc.
A current ratio of more than 1 indicates the capability of the company to meet its short term obligations. Whereas if the current ratio is below 1 it indicates that the company is not able to pay off their short-term liabilities with cash.
QUICK RATIO :
Quick ratio or Acid Test ratio is another liquidity ratio that determines a company’s current available liquidity. This ratio only considers those current assets that can be easily liquidated and converted into cash and is an indicator of how quickly the company is in a position to liquidate its current assets and repay all its current liabilities. It is calculated as –
Quick Ratio = (Cash + Marketable securities + Accounts receivable) / Current liabilities
The ideal quick ratio is 1:1 which reflects a financially stable position of the company.
CASH RATIO :
Cash or equivalent ratio measures a company’s most liquid assets such as cash and cash equivalent to the entire current liability of the concerned company. It is calculated as –
Cash Ratio = Cash and equivalent / Current liabilities
Thus, liquidity ratios are very important to determine the ability of a company to fulfill its short term financial obligations. A higher number is indicative of a sound financial position, while lower numbers show signs of financial distress.