# Liquidity Ratios

## Liquidity ratios measure how quickly assets can be turned into cash in order to pay the company's short-term obligations.

#### Key Points

• Liquidity ratios should fall within a certain range—too low and the company cannot pay off its obligations, or too high and the company is not utilizing its cash efficiently.

• Current Ratio = Current Assets / Current Liabilities. This ratio examines whether a firm can cover its short-term debts. If below 1, the company may have difficulty meeting short-term obligations.

• Acid Test Ratio (or Quick Ratio) = [Current Assets - Inventories] / Current Liabilities. More stringent and meaningful than the Current Ratio, since it does not include inventory. A ratio of 1:1 is recommended, but not necessarily a minimum.

• A company can improve its liquidity ratios by raising the value of its current assets, reducing current liabilities by paying off debt, or negotiating delayed payments to creditors.

#### Terms

• An asset's ability to become solvent without affecting its value; the degree to which it can be easily converted into cash.

• A person to whom a debt is owed.

• total cash and equivalents divided by short-term borrowings

#### Examples

• Company X has $1,000 dollars in cash, and$2,000 worth of inventory to be sold. Company X owed Company Y \$1,000 dollars. X's Current Ratio = 3000 / 1,000 = 3, and so can be considered healthy. X's Acid Test Ratio = 1,000 / 1,000 = 1, which means that it can pay off short-term obligations. It is also not too high, and so cash is not idle.

#### Figures

1. ##### Cash

Cash is the most liquid asset in a business.

Liquidity ratios measure a company's ability to pay short-term obligations of one year or less (i.e., how quickly assets can be turned into cash). A high liquidity ratio indicates that a business is holding too much cash that could be utilized in other areas. A low liquidity ratio means a firm may struggle to pay short-term obligations.

One such ratio is known as the current ratio, which is equal to:

Current Assets ÷ Current Liabilities.

This ratio reveals whether the firm can cover its short-term debts; it is an indication of a firm's market liquidity and ability to meet creditor's demands. Acceptable current ratios vary from industry to industry. For a healthy business, a current ratio will generally fall between 1.5 and 3. If current liabilities exceed current assets (i.e., the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, the company may be inefficiently using its current assets or its short-term financing facilities. This may also indicate problems in working capital management.

The acid test ratio (or quick ratio) is similar to current ratio except in that it ignores inventories. It is equal to:

(Current Assets - Inventories) ÷ Current Liabilities.

Typically the quick ratio is more meaningful than the current ratio because inventory cannot always be relied upon to convert to cash. A ratio of 1:1 is recommended. Low values for the current or quick ratios (values less than 1) indicate that a firm may have difficulty meeting current obligations. Low values, however, do not indicate a critical problem. If an organization has good long-term prospects, it may be able to borrow against those prospects to meet current obligations.

A firm may improve its liquidity ratios by raising the value of its current assets, reducing the value of current liabilities, or negotiating delayed or lower payments to creditors.

#### Key Term Glossary

asset
Something or someone of any value; any portion of one's property or effects so considered.
##### Appears in these related concepts:
assets
Any property or object of value that one possesses, usually considered as applicable to the payment of one's debts.
##### Appears in these related concepts:
business
a specific commercial enterprise or establishment
##### Appears in these related concepts:
capital
Money and wealth. The means to acquire goods and services, especially in a non-barter system.
##### Appears in these related concepts:
creditor
A person to whom a debt is owed.
##### Appears in these related concepts:
Current liabilities
In accounting, current liabilities are often understood as all liabilities of the business that are to be settled in cash within the fiscal year, or the operating cycle of a given firm, whichever period is longer.
##### Appears in these related concepts:
debt
Money that one person or entity owes or is required to pay to another, generally as a result of a loan or other financial transaction.
##### Appears in these related concepts:
demand
The desire to purchase goods or services, coupled with the power to do so, at a particular price.
##### Appears in these related concepts:
facility
The physical means or contrivances to make something (especially a service) possible; the required equipment, infrastructure, location etc.
##### Appears in these related concepts:
good
an object produced for market
##### Appears in these related concepts:
industry
The sector of the economy consisting of large-scale enterprises.
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inventory
The stock of an item on hand at a particular location or business.
##### Appears in these related concepts:
IT
Information Technology: the use of computers and telecommunications equipment to store, retrieve, transmit, and manipulate data.
liabilities
An amount of money in a company that is owed to someone and has to be paid in the future, such as tax, debt, interest, and mortgage payments.
##### Appears in these related concepts:
liquidity
An asset's ability to become solvent without affecting its value; the degree to which it can be easily converted into cash.
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liquidity ratio
total cash and equivalents divided by short-term borrowings
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management
administration; the process or practice of managing
##### Appears in these related concepts:
market
A group of potential customers for one's product.
##### Appears in these related concepts:
prospect
The potential things that may come to pass, often favorable.
##### Appears in these related concepts:
Prospect
A potential customer
##### Appears in these related concepts:
ratio
The relative magnitudes of two quantities (usually expressed as a quotient).
##### Appears in these related concepts:
test
A session in which a product or piece of equipment is examined under everyday or extreme conditions to evaluate its durability, etc.
##### Appears in these related concepts:
value
The degree of importance you give to something.
##### Appears in these related concepts:
values
A collection of guiding principles; what one deems to be correct and desirable in life, especially regarding personal conduct.