**The financial position of any company can be measured through various methods, but, one of the easiest and most efficient methods is by using the financial ratios and liquidity ratio is one such financial ratio.**

**Liquidity Ratio:**

Liquidity
of any company is defined as a firm’s ability to meet its short-term
liabilities or in simple words you can say that it measures how easily a
company can fulfill its obligations when they become due. So, a company’s
ability to pay its short-term debts is measured using liquidity ratio which can
easily be calculated by using the financial information provided in the
financial statements. Liquidity ratio is further divided into three main ratios
and measuring all three of them would give the analysts the right view of the
company’s efficiency in terms of liquidity.

**Current Ratio:**

The
liquidity of the company could be easily and directly measured using the
current ratio. It is actually defined as a company’s ability to pay its
short-term debt using its current assets. The formula that could be used to
calculate the current ratio is very simple and is as follow

There are two terms which are of concern to measure the ratio i.e. current assets and current liabilities. The current assets of any company include all the assets that it possess which could be converted into cash within a period of one year such as cash, account receivables, marketable securities etc. Similarly, the current liabilities are those debts that the company has to or can have to pay within a short period of one year. We can understand this ratio with the help of an example. Let’s suppose an ABC company has this information in its balance sheet

Current
Assets = $80,000 and Current Liabilities = $40,000

So,
the company’s current ratio will be 2 (80,000⁄40,000)

This
ratio of 2 means that the company has twice a number of assets as compared to
its debt i.e. for every $1 liability, a company has $2 to pay it. The current
ratio equal or greater than 1 is considered good for the company.

**Acid Ratio:**

The
acid ratio is also called as quick ratio and is another type of liquidity
ratio. The acid ratio measures a company’s ability to pay its short-term debt
with the most liquid assets that it possesses. The term liquid assets refer to
all those assets that could be readily converted into cash. The current assets
are mostly liquid assets with the exception of inventory that can take the time
to be converted into cash. So, this makes the formula for acid ratio to be:

It
is a relatively tougher measure for a company’s liquidity ability. Only the
information regarding the assets that are quickly converted into cash is
incorporated to find out the company’s quick ratio. For example, if a financial
analyst gets the following information from a company’s balance sheet

Cash
and Cash Equivalents = $ 40,000

Accounts
receivables = $ 20,000

Inventory
= $ 10,000

Short-Term
investment (that matures within 90 days) = $15,000

Current
Liabilities = $ 25,000

Then
he can easily calculate the Quick ratio as:

Quick
Ratio = 3 (( 40,000+20,000+15,000)⁄25000
)

This
quick ratio to be 3 is an indication that the company is financially stable as
it has $3 to pay each $1 of the debt. Acid Ratio equal to or greater than 1 s
considered good for the company.

**Cash Ratio:**

The
liquidity measurement is further narrowed down by measuring the cash ratio of
the company as it is the measure of the company to pay its short-term
liabilities with the help of cash reserves that it possess. No other current or
quick acid is involved while measuring the cash ratio. The formula for the Cash
Ratio is:

From
the balance sheet only these two items would be taken to calculate the cash
ratio.

For
example if the company’s current Cash reserves are $ 20,000 and the Short-term
investments are $10,000 and Accounts receivables is $ 20,000 whereas the
Current liabilities are $ 30,000

Then
the company cash ratio would be

Cash
Ratio = 1 ((20,000+10,000) ⁄30,000)

The
higher cash ratio is an indication of a company’s strong financial position.

These
are the three kinds of liquidity ratios that should be measured in order to
judge the company’s ability and efficiency in paying the short –term or current
debt. These ratios are important to be checked by those who want to invest in
the company.