An essential part of a company’s financial health is its ability to pay short-term bills. It doesn’t matter how great a company’s long-term potential is if it can’t cover its expenses. One of the main ways to assess this is by using liquidity ratios. This blog will examine the most common liquidity ratios and explain how they work.
What Are Liquidity Ratios?
Liquidity calculates a company’s financial health and helps us understand how a company pays its short-term bills using cash and other current assets. A higher liquidity ratio is always one of the safest zones. A low liquidity ratio leads to many problems and won’t attract investors.
Types of Liquidity Ratios
Liquid assets always help companies pay off short-term debts on time. Here some of the types of liquidity ratios are given below;
Current Ratio
The current Ratio shows how a company can pay its short-term bills for an overall 12 months. Investors consider this Ratio to determine whether further, they will invest in a certain company or not. It also tells us about how the company works. Some people call it the working capital ratio. To know the current Ratio, divide current assets by current liabilities:
Current Ratio = Current Assets / Current Liabilities
Most businesses consider 2 to be a good current Ratio. If it’s less than 1, the company might have trouble paying its short-term bills. To know more about this, join courses in accounting that will help you to get thorough knowledge on liquidity.
Quick Ratio
The quick Ratio reflects whether or not the particular company has cash. It is also called the acid test ratio. A good quick ratio for a financially healthy company is about 1. To find the quick Ratio, divide liquid current assets by current liabilities:
Quick Ratio = (Cash + Things that can be sold quickly + Money owed to the company) / Current Liabilities
Cash Ratio
The cash ratio shows how a company can pay its debts by using only cash or marketable securities. Using this cash ratio, investors should know how that particular company is correctly solving their short-term debts. To find the cash ratio, divide cash and cash equivalents by current liabilities:
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
Net Working Capital Ratio
The net working capital ratio helps us see if a company has enough cash or funds to keep going. You calculate it by subtracting current liabilities from current assets:
Net Working Capital Ratio = Current Assets – Current Liabilities
Importance of Liquidity Ratio
Let’s read about the importance of liquidity ratio;
- Liquidity ratios tell if a company can pay its short-term bills.
- A high liquidity ratio means the company is financially healthy. A low ratio suggests it might face bankruptcy.
- Investors like companies with high liquidity ratios because they reflect growth and stability.
- Low liquidity can signal financial problems for a company.
- Liquidity ratios can be analyzed by properly monitoring or comparing them with others. When liquidity ratios decline, financial risks occur, so investors must be careful.
- A higher risk will occur if the debts are not paid properly, especially within the due time. Gradually, this will also reflect in the liquidity ratio, as investors may drop the plan to invest further.
- If the quick Ratio improves, the company will have more cash or liquid assets, making it safer. This can attract more investors and raise the stock price.
Understanding liquidity ratios helps to handle all the problems that arise during financial situations. Analyzing liquidity ratios is essential for financial analysts to determine whether investing in a particular company is a sound decision. To understand more, consider the best job-oriented courses that help one gain more knowledge, leading to better career opportunities in the accounting sector.
