Explore the importance and functions of liquidity ratios, including the Current Ratio, Quick Ratio, and Cash Ratio, in evaluating a company's ability to meet both short- and long-term financial obligations.
Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and long-term obligations
- Current ratio measures a company’s ability to pay off short-term liabilities with current assets.
While the range of acceptable current ratios varies depending on the specific industry type, a ratio between 1.5 and 3 is generally considered healthy.
Current Ratio = Current Assets / Current Liabilities
In general, a good current ratio is anything over 1, with 1.5 to 2 being the ideal. If this is the case, the company has more than enough cash to meet its liabilities while using its capital effectively.
That being said, how good a current ratio depends on the type of company you’re talking about. It might be very common in certain industries to have current ratios lower than 1. Supermarkets, for instance, tend to operate at current ratios below 1 because they have few trade receivables, have a high level of trade payables, and have tight cash control.
- Quick Ratio (acid-test ratio) measures a company’s ability to pay off short-term liabilities with quick assets.
Quick Ratio = Current Assets - Inventories / Current Liabilities
A good quick ratio is any number greater than 1.0. If your business has a quick ratio of 1.0 or greater, that typically means your business is healthy and can pay its liabilities. The greater the number, the better off your business is.
- Cash Ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents.
Cash Ratio = Cash / Current Liabilities
A cash ratio is expressed as a numeral, greater or less than 1. Upon calculating the ratio, if the result is equal to 1, the company has exactly the same amount of current liabilities as it does cash and cash equivalents to pay off those debts.
Less Than 1: If a company's cash ratio is less than 1, there are more current liabilities than cash and cash equivalents. It means insufficient cash on hand exists to pay off short-term debt. This may not be bad news if the company has conditions that skew its balance sheets, such as lengthier-than-normal credit terms with its suppliers, efficiently-managed inventory, and very little credit extended to its customers.
Greater Than 1: If a company's cash ratio is greater than 1, the company has more cash and cash equivalents than current liabilities. In this situation, the company has the ability to cover all short-term debt and still have cash remaining.
It’s also important to compare the business in question to other businesses in their industry. If the current ratio for the business in question is lower than the industry average, that may indicate some serious cash flow problems.