Liquidity ratios: What is it?

Liquidity ratios are the ratios that measure the ability of a company to meet its short term debt obligations. These ratios measure the ability of a company to pay off its short-term liabilities when they fall due. The liquidity ratios are a result of dividing cash and other liquid assets by the short term borrowings and current liabilities. They show the number of times the short term debt obligations are covered by the cash and liquid assets. If the value is greater than 1, it means the short term obligations are fully covered. Generally, the higher the liquidity ratios are, the higher the margin of safety that the company posses to meet its current liabilities. Liquidity ratios greater than 1 indicate that the company is in good financial health and it is less likely fall into financial difficulties. Most common examples of liquidity ratios include current ratio, acid test ratio (also known as quick ratio), cash ratio and working capital ratio. Different assets are considered to be relevant by different analysts. Some analysts consider only the cash and cash equivalents as relevant assets because they are most likely to be used to meet short term liabilities in an emergency. Some analysts consider the debtors and trade receivables as relevant assets in addition to cash and cash equivalents. The value of inventory is also considered relevant asset for calculations of liquidity ratios by some analysts. The concept of cash cycle is also important for better understanding of liquidity ratios. The cash continuously cycles through the operations of a company. A companys cash is usually tied up in the finished goods, the raw materials, and trade debtors. It is not until the inventory is sold, sales invoices raised, and the debtors make payments that the company receives cash. The cash tied up in the cash cycle is known as working capital, and liquidity ratios try to measure the balance between current assets and current liabilities. A company must posses the ability to release cash from cash cycle to meet its financial obligations when the creditors seek payment. In other words, a company should posses the ability to translate its short term assets into cash. The liquidity ratios attempt to measure this ability of a company.

Current Ratio
Definition The current ratio is balance-sheet financial performance measure of company liquidity. The current ratio indicates a company's ability to meet short-term debt obligations. The current ratio measures whether or not a firm has enough resources to pay its debts over the next 12 months.

Potential creditors use this ratio in determining whether or not to make short-term loans. The current ratio can also give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. The current ratio is also known as the working capital ratio. Calculation (formula) The current ratio is calculated by dividing current assets by current liabilities: The current ratio = Current Assets / Current Liabilities Both variables are shown on the balance sheet (statement of financial position).

Norms and Limits

The higher the ratio, the more liquid the company is. Commonly acceptable current ratio is 2; it's a comfortable financial position for most enterprises. Acceptable current ratios vary from industry to industry. For most industrial companies, 1.5 may be an acceptable current ratio. Low values for the current ratio (values less than 1) indicate that a firm may have difficulty meeting current obligations. However, an investor should also take note of a company's operating cash flow in order to get a better sense of its liquidity. A low current ratio can often be supported by a strong operating cash flow. If the current ratio is too high (much more than 2), then the company may not be using its current assets or its short-term financing facilities efficiently. This may also indicate problems in working capital management. All other things being equal, creditors consider a high current ratio to be better than a low current ratio, because a high current ratio means that the company is more likely to meet its liabilities which are due over the next 12 months.

Acid-Test Ratio
The term Acid-test ratio is also known as quick ratio. The most basic definition of acid-test ratio is that, it measures current (short term) liquidity and position of the company. To do the analysis accountants weight current assets of the company against the current liabilities which result in the ratio that highlights the liquidity of the company. The formula for the acid-test ratio is: Quick ratio = (Current Assets Inventory) / Current liabilities

This concept is important as if the companys financial statements ( income statement, balance sheet) get through the analysis of the acid-test ratio, then the short term debts can be paid by the company. Example: Let us suppose that XYZ Company has total $2 million in its bank account and cash. The amount ofaccounts receivable (short term debitors of the XYZ company) is $11 million. The amount of short term investments is $4 million. The amount of Current liabilities (short term credit owed to others) is $12 million. So the Acid-Test ratio of Company X is (2million +11 million + 4 million ) / (12 mill) = 1. 33. If the value of the acid-term ratio is less than 1, then it is said that such a company is not stable and may face difficulty is paying off their debts (short term). In order to clear the short term debts they probably would need to sell some of their assets. But such an option affects the overall position of the company because if the company owns very little assets. The biggest advantage of acid-test ratio is that it helps the company in understanding the end results very feasibly. The only major issue with the acid-test ratio is its dependence of the accounts receivable and current liabilities which can cause trouble. If due to any dispute the contract with the creditor or debtors gets messed up whole of the process gets unbalanced. And also, a minor mistake in the calculation can just destroy and conclude misleading outcomes.