Liquidity Ratio

It’s a ratio that tells one’s ability to pay off its debt as and when they become due. In other words, we can say this ratio tells how quickly a company can convert its current assets into cash so that it can pay off its liability on a timely basis. Generally, Liquidity and short-term solvency are used together.

The usefulness of liquidity ratio

The liquidity ratio affects the credibility of the company as well as the credit rating of the company. 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.

Formulas

Under liquidity ratio there are several more ratios, which come into the picture for checking how financially, sound a company is:

I. Current Ratio

II. Acid Test Ratio or Quick Ratio

Current Ratio

This ratio measures the financial strength of the company. Generally, 2:1 is treated as the ideal ratio, but it depends on industry to industry.

Formula: Current Assets/ Current Liability, where

A. Current Assets = Stock, debtor, cash and bank, receivables, loan and advances, and other current assets.

B. Current Liability = Creditor, short-term loan, bank overdraft, outstanding expenses, and other current liability.

Acid Test Ratio or Quick Ratio

This ratio is the best measure of liquidity in the company. This ratio is more conservative than the current ratio. The quick asset is computed by adjusting current assets to eliminate those assets which are not in cash.

Generally, 1:1 is treated as an ideal ratio.

Formula: Quick Assets/ Current Liability, where,

Quick Assets = Current Assets – Inventory – Prepaid Expenses

Absolute liquidity ratio

This ratio measures the total liquidity available to the company. This ratio only considers marketable securities and cash available to the company. This ratio only tests short-term liquidity in terms of cash, marketable securities, and current investment. Formula: Cash + Marketable Securities / Current Liability

Basic Defense Ratio

This ratio measures the no. of days a company can cover its Cash expenses without the help of additional financing from other sources.

Formula: (Cash + Receivables + Marketable Securities) ÷ (Operating expenses +Interest + Taxes) ÷ 365

Example:

Particulars	Amount
Cash and Cash Equivalent	2188
Short-Term Investment	65
Receivables	1072
Stock	8338
Other Current Assets	254
Total Current Assets	11917
Accounts Payable	4560
Outstanding Expenses	809
Taxes Payable	307
Deferred Revenue	998
Income Tax Payable	227
Other Outstanding Expenses	1134
Total Current Liability	8035

Additional Details:

Operating Expenses during the year is 2188
Net Interest paid during the year is 25
Taxes paid/ for the year is 1913
Current Ratio = Current Assets/Current Liability = 11971 ÷8035 = 1.48
Quick Ratio = (Current Assets- Inventory)/Current Liability = (11971-8338)÷8035 = 0.45
Basic Defense Interval = (Cash + Receivables + Marketable Securities) ÷ (Operating expenses +Interest + Taxes)÷365 = (2188+1072+65)÷(11215+25+1913)÷365 = 92.27
Absolute liquidity ratio =(Cash + Marketable Securities)÷ Current Liability =(2188+65) ÷ 8035 = 0.28

Liquidity Ratio – Definition, Formula With Examples (1)

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FAQs

Liquidity Ratio – Definition, Formula With Examples? ›

The liquidity ratio is a computation used to measure the ability of the company to pay its short-term debt. It can be calculated by using the current ratio, the quick ratio (or acid-test ratio), and the cash ratio. The current ratio is equal to current assets divided by current liabilities.

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How to calculate liquidity ratio with an example? ›

Types of liquidity ratios

Current Ratio = Current Assets / Current Liabilities.
Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities.
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.
Net Working Capital = Current Assets – Current Liabilities.

What is the formula for liquidity? ›

It is calculated by dividing total current assets by total current liabilities. A higher ratio indicates the company has enough liquid assets to cover its short-term debts. In comparison, a low ratio suggests that the company may not have enough cash or other liquid assets to cover its immediate liabilities.

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What is the explanation for liquidity ratio? ›

Liquidity ratios are a measure of the ability of a company to pay off its short-term liabilities. Liquidity ratios determine how quickly a company can convert the assets and use them for meeting the dues that arise. The higher the ratio, the easier is the ability to clear the debts and avoid defaulting on payments.

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What is liquidity ratio in accounting formula? ›

Liquidity ratio measures a company's ability to pay off debts promptly. It affects credibility and credit rating, with various formulas including Current Ratio, Acid Test Ratio, Absolute Liquidity Ratio, and Basic Defense Ratio used to assess financial soundness.

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How to calculate quick liquidity ratio? ›

To find your company's quick ratio, first add together your cash, accounts receivable, and marketable securities to find your quick assets. Add together your accounts payable and short-term debt to find current liabilities. Then, divide your quick assets by current liabilities to find your quick ratio.

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What is liquidity with example? ›

Liquidity is a company's ability to convert assets to cash or acquire cash—through a loan or money in the bank—to pay its short-term obligations or liabilities. How much cash could your business access if you had to pay off what you owe today —and how fast could you get it? Liquidity answers that question.

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What does a liquidity ratio of 1.5 mean? ›

For instance, a quick ratio of 1.5 indicates that a company has $1.50 of liquid assets available to cover each $1 of its current liabilities. While such numbers-based ratios offer insight into the viability and certain aspects of a business, they may not provide a complete picture of the overall health of the business.

How do you calculate current ratio and liquidity? ›

You can calculate the current ratio by dividing a company's total current assets by its total current liabilities. Again, current assets are resources that can quickly be converted into cash within a year or less, including cash, accounts receivable and inventories.