Liquidity is a very critical part of a business. Liquidity is required for a business to meet its short term obligations. Liquidity ratios are a measure of the ability of a company to pay off its short-term liabilities.
Liquidity ratios determine how quickly a company can convert the assets and use them for meeting the dues that arise. The higher the ratio the more easier is the ability to clear the debts and avoid defaulting on payments.
This is a very important criteria that creditors check before offering short term loans to the business. An organization which is unable to clear dues results in creating impact on the creditworthiness and also affects credit rating of the company.
Let us now discuss the different types of liquidity ratios.
Types of Liquidity Ratio
There are following types of liquidity ratios:
- Current Ratio or Working Capital Ratio
- Quick Ratio also known as Acid Test Ratio
- Cash Ratio also known Cash Asset Ratio or Absolute Liquidity Ratio
- Net Working Capital Ratio
- Basic Defence Ratio or Defensive Interval Ratio
Let us know more in detail about these ratios.
Current Ratio or Working Capital Ratio
The current ratio is a measure of a company’s ability to pay off the obligations within the next twelve months. This ratio is used by creditors to evaluate whether a company can be offered short term debts. It also provides information about the company’s operating cycle. It is also popularly known as Working capital ratio. It is obtained by dividing the current assets with current liabilities.
Current ratio ratio is calculated as follows:
Current ratio = Current Assets / Current Liabilities
A higher current ratio around 2 is suggested to be ideal for most of the industries while a lower value (less than 1) is indicative of a firm having difficulty in meeting its current liabilities.
Quick Ratio or Acid Test Ratio
Quick ratio also known as Acid test ratio is used to determine whether a company or a business has enough liquid assets which are able to be instantly converted into cash to meet short term dues. It is calculated by dividing the liquid current assets by the current liabilities
It is represented as
Quick Ratio = (Cash + Marketable securities + Accounts receivable) / Current liabilities
Ideal quick ratio should be 1 for a financially stable company.
Cash Ratio or Absolute Liquidity Ratio
Cash ratio is a measure of a company’s liquidity in which it is measured whether the company has the ability to clear off debts only using the liquid assets (cash and cash equivalents such as marketable securities). It is used by creditors for determining the relative ease with which a company can clear short term liabilities.
It is calculated by dividing the cash and cash equivalents by current liabilities.
Cash ratio = Cash and equivalent / Current liabilities
Net Working Capital Ratio
The net working capital ratio is used to determine whether a company has sufficient cash or funds to continue its operations. It is calculated by subtracting the current liabilities from the current assets.
Net Working Capital Ratio = Current Assets – Current Liabilities
Basic Defence Ratio or Defensive Interval Ratio
This is a ratio that is used to determine the number of days a company can run its operations without needing to use the noncurrent assets or long term assets. It is used alongside quick ratio and current ratio in determining liquidity position of a company.
It is calculated by dividing the current assets by the daily operational expenses.
Basic Defence Ratio = Current assets / Daily operational expenses
Where Current assets = Cash and Cash Equivalents + Net Receivables + Market Securities
Liquidity Ratio Formula
Here are the important liquidity ratio formulas in a tabular format.
Current Assets / Current Liabilities
(Cash + Marketable securities + Accounts receivable) / Current liabilities
Cash and equivalent / Current liabilities
Net Working Capital Ratio
Current Assets – Current Liabilities
Basic Defence Ratio
Current assets / Daily operational expenses
Importance of Liquidity Ratio
Here are some of the importance of liquidity ratios:
- It helps understand the availability of cash in a company which determines the short term financial position of the company. A higher number is indicative of a sound financial position while lower numbers show signs of financial distress.
- It also shows how efficiently the company is able to convert inventories into cash. It determines the way a company operates in the market.
- It helps in organising the company’s working capital requirements by studying the levels of cash or liquid assets available at a certain time.
This concludes the article on the concept of the liquidity ratios. It will provide ample information for the students to understand liquidity ratios which provides a solid basis for calculating the liquidity position of a company. For more such exciting concepts, stay tuned to BYJU’S.
Frequently Asked Questions on Liquidity Ratio
What is SLR?
SLR is known as statutory liquidity ratio. It is the minimum percentage of deposit that a commercial bank needs to maintain in the form of cash, securities and gold before offering credit to customers. Current SLR is 21.50% in India.
What is Liquidity Coverage Ratio?
Liquid coverage ratio is the proportion of high liquid assets that banks need to maintain short term debts or liabilities.
What is a good liquidity ratio?
A good liquidity ratio can be any value that is greater than 1. It indicates that a company is having sound financial position and is able to meet short-term obligations efficiently.
What are three types of liquidity ratios?
The three types of liquidity ratios are current ratio, quick ratio and cash ratio. These are useful in determining the liquidity of a company.
What are the most common liquidity ratios
The most common liquidity ratios are current ratio and quick ratio. These are very useful ratios for calculating a company’s ability to pay short term liabilities.