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 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.
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.
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.
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.