The cash ratio measures a company’s ability to meet short-term obligations using only cash and cash equivalents (e.g. marketable securities). 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. Inventory may not be that easy to convert into cash, and so may not be a good indicator of liquidity. A company must have more total assets than total liabilities to be solvent; a company must have more current assets than current liabilities to be liquid. Although solvency does not relate directly to liquidity, liquidity ratios present a preliminary expectation regarding a company’s solvency. For investors, they will analyze a company using liquidity ratios to ensure that a company is financially healthy and worthy of their investment.

The more ready cash you have to cover your debt repayments, rent, employee salary, utilities, and other fixed expenses, the less you have to worry about cash-flow crises that could stymie your operation. Asking the question regarding an institution’s liquidity ratio to a bank officer is the simplest approach. You can ask the question in person, via email, or you may even be able to find the information on the bank’s website. Remember that since liquidity ratios can and do change over time, it never hurts to ensure that the figure received is current.

Liquidity ratio

Days Sales Outstanding (DSO) is a financial metric that measures the average number of days a company takes to collect payment after a sale. Calculate it by dividing a company’s accounts receivable by its average daily sales. A lower DSO indicates that a company can collect payments more quickly, improving its cash flow and reducing its exposure to credit risk.

Given the structure of the ratio, with assets on top and liabilities on the bottom, ratios above 1.0 are sought after. A ratio of 1 means that a company can exactly pay off all its current liabilities with its current assets. A ratio of less than 1 (e.g., 0.75) would imply that a company is not able to satisfy its current liabilities. Current ratio is often compared to other liquidity ratios such as the acid test ratio. In fact, at first glance, there’s very little difference between these two ratios.

The Current Ratio

With liquidity ratios, there is a balance between a company being able to safely cover its bills and improper capital allocation. Capital should be allocated in the best way to increase the value of the firm for shareholders. Therefore, an acceptable current ratio will be higher than an acceptable quick ratio. For example, a company may have a current ratio of 3.9, a quick ratio of 1.9, and a cash ratio of 0.94.

There are three different formulas that can be used to calculate liquidity – the current ratio, the quick ratio, and the cash ratio. It is defined as the ratio between quickly available or liquid assets and current liabilities. Quick assets are current assets that can presumably be quickly converted to cash at close to their book values.

Example using quick ratio

Inventory Turnover shows how many times do the stocks of a product are cleared within a given timeframe. Therefore, we must concentrate on the number the inventory that is filled and cleared. Information and views provided are general in nature and are not legal, tax, or investment advice. Information and suggestions regarding business risk management and safeguards do not necessarily represent Wells Fargo’s business practices or experience.

Liquidity Ratio Definition & Meaning

Note that in our example, we will assume that current liabilities only consist of accounts payable and other liabilities, with no short-term debt. But unless the financial system is in a credit crunch, a company-specific liquidity crisis can be resolved relatively easily with a liquidity injection (as long as the company is solvent). This is because the company can pledge some assets if it is required to raise cash to tide over the liquidity squeeze. This route may not be available for a company that is technically insolvent because a liquidity crisis would exacerbate its financial situation and force it into bankruptcy.

Quick ratio

Bankers and merchants first used them in the 19th century to determine how healthy a company’s finances were. The first liquidity ratios, like the current ratio, were https://kelleysbookkeeping.com/ used to determine if a company had enough assets to pay off its debts. The cash ratio compares just cash and readily convertible investments to current liabilities.

  • The first liquidity ratios, like the current ratio, were used to determine if a company had enough assets to pay off its debts.
  • For example, internal analysis regarding liquidity ratios involves using multiple accounting periods that are reported using the same accounting methods.
  • Although solvency does not relate directly to liquidity, liquidity ratios present a preliminary expectation regarding a company’s solvency.
  • Any hint of financial instability may disqualify a company from obtaining loans.

That is, the current ratio is defined as current assets/current liabilities. A higher liquidity ratio means that your business has a more significant margin of safety with regard to your ability to pay off debt obligations. But it’s also important to remember that if your liquidity ratio is too high, it may indicate that you’re keeping too much cash on hand Liquidity Ratio Definition & Meaning and aren’t allocating your capital effectively. Instead, you could use that cash to fund growth initiatives or investments, which will be more profitable in the long run. 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.