What do Liquidity Ratios tell?

Every company has some or other liabilities. These liabilities are short-term and long-term. Short-term liabilities refers to those which are due to pay within 12 months. Long-term liabilities, as understood, refers to those which have to be paid after the running financial year.  

Liquidity Ratios gives an idea of how capable a firm is to pay its short-term dues. This financial ratio tells how competent an entity is to pay these obligations with their current assets and without any financial assistance. Higher the liquidity ratio, better for a company. 

Liquidity Ratio Metrics

Current Ratio: Current Assets/ Current Liabilities

This ratio indicates a company’s ability to pay off its current liabilities (short-term liabilities) with its current assets. These current assets consist of cash, inventories, marketable securities and accounts receivables.

Quick Ratio: (Current Assets – Inventories)/ Current Liability

As the name suggests, quick ratio involves those current assets that can be easily converted into cashInventories are part of current assets but are not the most liquid form of current assets. Inventories may take time to be sold and thus quick ratio does not take inventories into account. Thus, this ratio is also known as “Acid-test ratio.”

Cash Ratio: Cash/Current Liability

Company’s most liquid assets are cash. Cash Ratio indicates the ability of the firm to pay its short-term liabilities with its most liquid form of asset. Generally, investors trust a company more with higher cash ratio. They believe that the company has enough cash to pay them even if the business doesn’t turn out to be profitable. 

Example

Imagine a company ABC has following particulars:

Cash10000
Inventories5000
Accounts receivables5000
Current Liabilities25000

Current Ratio = (10000+5000+5000)/25000 = 0.8 (In Current Ratio, all the current assets are taken.)

Quick Ratio = (20000-5000)/25000 = 0.6 (Inventories are not a part of quick assets, hence it is subtracted from current assets.)

Cash Ratio = 10000/20000 = 0.5 (Cash Ratio considers only cash as the current assets, as it is the most liquid form of assets)