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Liquidity ratios measure how quickly assets can be turned into cash in order to pay the company's short-term obligations.
Compare the current ratio to the quick ratio
Liquidityratios 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.
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.
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 capitalmanagement.
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.