Business Ratios Guidebook
Key Performance Indicators
The Interpretation of Financial Statements
What are Liquidity Ratios?
Liquidity ratios are measurements used to examine the ability of an organization to pay off its short-term obligations. Liquidity ratios are commonly used by prospective creditors and lenders to decide whether to extend credit or debt, respectively, to companies. These ratios compare various combinations of relatively liquid assets to the amount of current liabilities stated on an organization's most recent balance sheet. The higher the ratio, the better the ability of a firm of pay off its obligations in a timely manner.
Shortcomings of Liquidity Ratios
A possible concern with using liquidity ratios is that the current liabilities of a business may not be coming due for payment on the same dates when the offsetting current assets can be liquidated, so even a robust liquidity ratio can mask a potential cash shortfall. Another concern is that these ratios do not take into account the ability of a business to borrow money; a large line of credit will counteract a low liquidity ratio.
The current ratio compares current assets to current liabilities. The intent behind using it is to see if there are sufficient current assets on hand to pay for current liabilities, if the current assets were to be liquidated. Its main flaw is that it includes inventory as a current asset. Inventory may not be that easy to convert into cash, and so may not be a good indicator of liquidity.
The quick ratio is the same as the current ratio, but excludes inventory. Consequently, most remaining assets should be readily convertible into cash within a short period of time. This is perhaps the best liquidity ratio for evaluating whether a business has sufficient short-term assets on hand to meet its current obligations.
The cash ratio compares just cash and readily convertible investments to current liabilities. As such, it is the most conservative of all the liquidity ratios, and so is useful in situations where current liabilities are coming due for payment in the very short term. In most cases, it is an excessively conservative way to evaluate the liquidity of a business.