Liquidity Ratio

Liquidity Ratios

Financial ratios that measure a company's ability to repay both short- and long term obligations

Current Ratio


Measures a company’s ability to pay short-term obligations & liabilities or those due within one year

FORMULA:

= Current assets / Current liabilities

Example Current Ratio


If a company has the following financial information: - Current Assets = €150000 - Current Liabilities = €100000 Then, the current ratio would be calculated as follows: Current Ratio = Current assets / Current liabilities = 150000 /100000 = 1.5

• Current Ratio > 1: company has more current assets than current liabilities, suggesting good short-term financial health.

• Current Ratio = 1: current assets equal current liabilities, suggesting that the company can cover its short-term obligations.

• Current Ratio < 1: current liabilities exceed current assets, which may raise concerns about the company’s liquidity & ability to meet short-term obligations.

Acid-Test Ratio or Quick Ratio


measures how sufficient a company's short-term assets are to cover its current liabilities. In other words, the acid-test ratio is a measure of how well a company can satisfy its short-term (current) financial obligations. 

• Compares a company's "quick assets" (current assets convertible in cash - inventories) to its current or immediate liabilities. Not relying on the sale of inventory that could take more time

FORMULA:

= (Cash + Cash Equivalents + Shortterm Investments + Marketable Securities + Current Receivables) / Current Liabilities

formula can also be= current assets - inventory / current liabilities

Example Acid-Test Ratio


If a company has current assets of $500000, inventory of $150000, and current liabilities of $300000, the ratio would be:

Acid-Test Ratio = Current Assets − Inventory Current Liabilities = 500000− 150000 300000 = 1.17

Interpretation:

• A ratio greater than 1 indicates that the company can meet its short-term obligations without relying on the sale of inventory.

• A lower ratio may indicate liquidity issues.

Considerations:

• very high ratio may indicate that the company is not effectively using its assets to generate revenue.

• The industry standard can vary, so it’s essential to compare with peers.

Cash Ratio

liquidity metric that indicates a company’s capacity to pay off short-term liabilities with its cash and cash equivalents. Most conservative liquidity position.

Compared to other liquidity ratios such as the current ratio, cash ratio is a stricter, more conservative measure because only cash & cash equivalents  – a company’s most liquid assets – are used in the calculation.

FORMULA:

= Cash + Cash Equivalents / Current Liabilities

Operating Cash Flow Ratio

Indicates if company's normal operations are sufficient to cover its near-term obligations. Provides vital info on company’s health.

• measures a company’s ability to cover its current liabilities w/cash generated from its operating activities

represents a company's ability to pay its debts with its existing cash flows. It is determined by dividing operating cash flow by current liabilities. A ratio greater than 1.0 indicates that a company is in a strong position to pay its debts without incurring additional liabilities.

FORMULA:

= Operating Cash Flow / Current Liabilities