20 years: Chartered accountant & educator

Liquidity ratios are essential indicators of a firm's financial health, they measure the ability of a company to meet its short-term obligations. Saket stresses the importance of this ratio and highlights the calculations of; the current ratio, quick ratio, and the cash ratio.

Liquidity ratios are essential indicators of a firm's financial health, they measure the ability of a company to meet its short-term obligations. Saket stresses the importance of this ratio and highlights the calculations of; the current ratio, quick ratio, and the cash ratio.

3 mins 34 secs

Overview

Liquidity and solvency are important parts of a company’s financial health. They measure the company’s ability to pay its bills when due. The liquidity ratios measure the ability of a company to meet its short-term obligations, say in the next 12 months. There are three liquidity ratios that can be calculated based on the information in the balance sheet or the statement of financial position of a non-financial institution: the current ratio, the quick ratio (which is also known as the acid-test ratio), and the cash ratio.

Key learning objectives:

Outline the benefits of liquidity ratios

Understand how the different liquidity ratios are calculated

Summary#### What are the benefits of liquidity ratios?

#### What is the Current Ratio, and how is it calculated?

#### What is the Quick Ratio, and how do we calculate its value?

#### What is the Cash Ratio, and how do we calculate it?

The liquidity ratios measure the ability of a company to meet its short-term obligations, say in the next 12 months. If a company does not have sufficient liquidity, it may be necessary to analyse whether it would be able to remain solvent and continue in operation in the longer term.

It may be useful to compare the liquidity ratios with the previous period end to see if it is improving or worsening. It may also be compared to similar companies in the industry. If the current assets of a company are less than the current liabilities. it may not be able to meet its short-term obligations unless additional funds are raised.

The Current Ratio is calculated by dividing the total current assets by the total current liabilities. It shows whether the cash balance and the assets which are convertible to cash in the next 12 months are sufficient to meet the obligations in the next 12 months.

**Current ratio = Current assets / Current liabilities**

The Quick Ratio which is also referred to as the Acid-Test Ratio shows to what extent the company is capable of paying off the short-term obligations with assets that are easily convertible to cash. In this ratio, the inventories value is deducted from the current assets, and the resulting amount is divided by the current liabilities. If a company has inventories, the quick ratio will always be lower than the current ratio.

**Quick ratio = (Current assets – Inventories) / Current liabilities**

The Cash Ratio shows the extent to which the company is able to service the short-term obligations with cash and cash equivalents.

**Cash ratio = Cash and cash equivalents / Current liabilities**

Saket is a financial trainer and consultant based out of London. He specialises in advanced accounting, financial reporting and financial analysis, particularly with regards to International Financial Reporting Standards (IFRS), International Public Sector Accounting Standards (IPSAS) and Financial instruments.

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