The two categories of ratios that should be utilized to assess a firm’s true liquidity are the

Types of Liquidity Ratios

1. Current Ratio

Current Ratio = Current Assets / Current Liabilities

The current ratio is the simplest liquidity ratio to calculate and interpret. Anyone can easily find the current assets and current liabilities line items on a company’s balance sheet. Divide current assets by current liabilities, and you will arrive at the current ratio.

2. Quick Ratio

Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities

The quick ratio is a stricter test of liquidity than the current ratio. Both are similar in the sense that current assets is the numerator, and current liabilities is the denominator.

However, the quick ratio only considers certain current assets. It considers more liquid assets such as cash, accounts receivables, and marketable securities. It leaves out current assets such as inventory and prepaid expenses because the two are less liquid. So, the quick ratio is more of a true test of a company’s ability to cover its short-term obligations.

3. Cash Ratio

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

The cash ratio takes the test of liquidity even further. This ratio only considers a company’s most liquid assets – cash and marketable securities. They are the assets that are most readily available to a company to pay short-term obligations.

In terms of how strict the tests of liquidity are, you can view the current ratio, quick ratio, and cash ratio as easy, medium, and hard.

Important Notes

Since the three ratios vary by what is used in the numerator of the equation, an acceptable ratio will differ between the three. It is logical because the cash ratio only considers cash and marketable securities in the numerator, whereas the current ratio considers all current assets.

Therefore, an acceptable current ratio will be higher than an acceptable quick ratio. Both will be higher than an acceptable cash ratio. For example, a company may have a current ratio of 3.9, a quick ratio of 1.9, and a cash ratio of 0.94. All three may be considered healthy by analysts and investors, depending on the company.

Importance of Liquidity Ratios

1. Determine the ability to cover short-term obligations

Liquidity ratios are important to investors and creditors to determine if a company can cover their short-term obligations, and to what degree. A ratio of 1 is better than a ratio of less than 1, but it isn’t ideal.

Creditors and investors like to see higher liquidity ratios, such as 2 or 3. The higher the ratio is, the more likely a company is able to pay its short-term bills. A ratio of less than 1 means the company faces a negative working capital and can be experiencing a liquidity crisis.

2. Determine creditworthiness

Creditors analyze liquidity ratios when deciding whether or not they should extend credit to a company. They want to be sure that the company they lend to has the ability to pay them back. Any hint of financial instability may disqualify a company from obtaining loans.

3. Determine investment worthiness

For investors, they will analyze a company using liquidity ratios to ensure that a company is financially healthy and worthy of their investment. Working capital issues will put restraints on the rest of the business as well. A company needs to be able to pay its short-term bills with some leeway.

Low liquidity ratios raise a red flag, but “the higher, the better” is only true to a certain extent. At some point, investors will question why a company’s liquidity ratios are so high. Yes, a company with a liquidity ratio of 8.5 will be able to confidently pay its short-term bills, but investors may deem such a ratio excessive. An abnormally high ratio means the company holds a large amount of liquid assets.

For example, if a company’s cash ratio was 8.5, investors and analysts may consider that too high. The company holds too much cash on hand, which isn’t earning anything more than the interest the bank offers to hold their cash. It can be argued that the company should allocate the cash amount towards other initiatives and investments that can achieve a higher return.

With liquidity ratios, there is a balance between a company being able to safely cover its bills and improper capital allocation. Capital should be allocated in the best way to increase the value of the firm for shareholders.

More Resources

This has been CFI’s guide to Liquidity Ratio. To keep advancing your career, the additional CFI resources below will be useful:

Financial ratios are measurements of a business' financial performance. Ratios help an owner or other interested parties develop an understand the overall financial health of the company.

Financial ratios are used by businesses and analysts to determine how a company is financed. Ratios are also used to determine profitability, liquidity, and solvency. Liquidity is the firm's ability to pay off short term debts, and solvency is the ability to pay off long term debts.

Commonly used financial ratios can be divided into the following five categories.

Liquidity ratios focus on a firm's ability to pay its short-term debt obligations. The information you need to calculate these ratios can be found on your balance sheet, which shows your assets, liabilities, and shareholder's equity.

Common liquidity ratios are the current ratio, the quick ratio, and the cash ratio. The current ratio is an indicator of your company's ability to pay its short term liabilities (debts).

The quick ratio (sometimes called the acid-test) is similar to the current ratio. The difference between the two is that in the quick ratio, inventory is subtracted from current assets. Since inventory is sold and restocked continuously, subtracting it from your assets results in a more precise visual than the current ratio.

The cash ratio is different from both the quick and current ratios in that it only takes into account assets that are the easiest to convert into cash. These assets are cash and cash equivalents, such as marketable securities, money orders, or money in a checking account.

The solvency ratio represents the ability of a company to pay it's long term obligations. This ratio compares your company's non-cash expenses and net income after taxes to your total liabilities (short term and long term).

The financial leverage or debt ratios focus on a firm's ability to meet its long-term debt obligations. They use the firm's long-term liabilities on the balance sheet such as payable bonds, long-term loans, or pension funds.

Common financial leverage ratios are the debt to equity ratio and the debt ratio. Debt to equity refers to the amount of money and retained earnings invested in the company.

The debt ratio indicates how much debt the firm is using to purchase assets. In other words, it shows if the company uses debt or equity financing.

Sometimes called asset efficiency ratios, turnover ratios measure how efficiently a business is using its assets. This ratio uses the information found on both the income statement and the balance sheet.

The turnover ratios used most commonly are accounts receivable turnover, accounts payable turnover, and inventory turnover. Accounts receivable turnover indicate how effective your company is at collecting credit debt.

Accounts payable turnover expresses your efficiency at paying your accounts, and inventory turnover is a measurement of the amount of time it takes to consume and restock your inventory.

When used together, turnover ratios describe how well the business is being managed. They can indicate how fast the company's products are selling, how long customers take to pay, or how long capital is tied up in inventory.

These are ratios that measure if a business' activities are profitable. Frequently used ratios are the net profit ratio and the contribution margin ratio. The contribution margin ratio indicates if your products or services are generating a profit after variable expenses.

The net profit ratio expresses profits after taxes to net sales. This ratio illustrates the percentage of profits remaining after taxes and all costs have been accounted for.

There are many market value ratios, but the most commonly used are price per earnings (P/E) and dividend yield.

The P/E ratio is used by investors to determine if a share of a company's stock is over or underpriced. The dividend yield is an important ratio for investors as it illustrates the return on their investment.