Liquidity ratios are a set of financial ratios that measure the company’s short term liquidity and its ability to pay its short-term obligations without raising additional capital. Investors use those ratios to identify the company’s margin of safety, as in general higher liquidity ratios, indicates a better financial position.
There are three major liquidity ratios
- Current ratio
- Quick ratio
- Cash ratio
Current ratio measures the company’s ability to pay its current liabilities (short-term debt obligations) using its current assets. Current liabilities are usually due within one year or less.
|Current Assets||Current Liabilities|
Other current assets
Other current liabilities
Current ratio can be calculated through this formula:
Current ratio = current assets / current liabilities
An average or slightly higher current ratio of a company compared to its industry means that the company is able to pay its short-term obligations that are due within one year. A lower current ratio indicates that the company might be in distress or default, while a significantly higher ratio might indicate that the company can’t use its current assets efficiently.
Quick ratio measures a company’s short-term liquidity and its ability to meet its short-term obligations with its most liquid assets. The quick ratio is considered a more conservative metric than current ratio because it indicates the company’s ability to pay for its obligations without the need to sell its inventory.
Quick ratio can be calculated through this formula:
Cash ratio is even a more conservative metric that assumes the company won’t be able to sell its inventory and won’t be able to get its accounts receivable. It only relies on cash to cover short term obligations.
Cash ratio can be calculated through the following formula: