Liquidity ratios are used to measure the ability of a company to pay its short-term debts using liquid assets which can be converted to cash quickly. In this section, we cover the most important liquidity ratios you need to know.
What are liquidity ratios?
Liquidity ratios are metrics that speak of a company’s capacity to cover its financial obligations as soon as they are due. Specifically, these numbers show how many times over short-term liabilities can be paid using the business’ cash and liquid assets. Higher liquidity ratios are generally safer as far as a company’s ability to settle its current liabilities is concerned. Liquidity ratios above 1 show that the business is in a favorable fiscal position and is unlikely to encounter hardships.
Various assets may be considered relevant, depending on the analyst. Some say only cash and cash equivalents count as relevant assets because short-term liabilities will probably be paid in cash. For others, debtors and trade receivables should qualify as relevant, while yet others consider the value of inventory relevant in liquidity ratio calculations.
The cash cycle is another vital concept to study for those who seek a greater understanding of liquidity ratios. Cash normally moves around a company’s operations and is tied up until the inventory is sold and the company receives the payment in cash. But until that payment is made, the money going around in the cash cycle is called working capital, where liquidity ratios are metrics that determine the balance between the company’s current assets and current liabilities.
Before a company can meet its financial obligations, it must first extract cash from the cash cycle so that creditors can be paid. In short, a company should have the capacity to convert its short-term assets into cash. That’s exactly what liquidity ratios attempt to assess.
List of liquidity ratios
Below is the complete list of liquidity ratios we have covered. Each will provide a detailed overview of the ratio, what it’s used for, and why.
They also explain the formula behind the ratio and provide examples and analysis to help you understand them.
- Net Working Capital
- Current Ratio
- Quick Ratio
- Cash Ratio
- Cash Conversion Cycle (CCC)
- Working Capital Ratio
- Z-Score
- Days Sales Outstanding (DSO)
- Average Inventory Period
- Days Payable Outstanding (DPO)
- Defensive Interval Ratio (DIR)
- Average Payment Period (APP)
- Sales to Working Capital Ratio
- Cash to Current Liabilities Ratio
- Working Capital to Debt Ratio
- Cash Flow Adequacy Ratio
- Sales to Current Assets Ratio
- Cash to Current Assets Ratio
- Cash to Working Capital Ratio
- Inventory to Working Capital Ratio
- Net Debt
More financial ratios
FAQs
1. What are liquidity ratios?
Liquidity ratios are metrics that speak of a company’s capacity to cover its financial obligations as soon as they are due. Specifically, these numbers show how many times over short-term liabilities can be paid using the business’ cash and liquid assets.
2. What are the types of liquidity ratios?
There are many types of liquidity ratios, but the most important ones are the current ratio, quick ratio, and cash ratio.
3. How does liquidity ratio differ from solvency ratio?
Solvency ratios measure how much of a company's long-term liabilities can be paid with its assets. Liquidity ratios, on the other hand, measure how easily a company can pay its short-term liabilities.
4. Why are liquidity ratios important?
Liquidity ratios are important because they give analysts and creditors an idea of how easily a company can pay its short-term liabilities. A high liquidity ratio means that the company is in a strong financial position and is unlikely to face difficulties in meeting its obligations.
4. What is a good liquidity ratio?
A good liquidity ratio would be one that is above 1. This means that the company has more liquid assets than short-term liabilities, which indicates a strong financial position.
