Financial Accounting Concepts

What are Liquidity Ratios? – Meaning and Formula

Liquidity ratios measure the short-term financial solvency of a business. Here the short term refers to a period of 12 months or lesser.

Investors typically use liquidity ratios to determine the worth of a company’s assets. If the ratio is high, it means that there are more liquid assets available for quick conversion to cash if needed. Most companies, however, will have a negative liquidity ratio because they owe money rather than own it.

Uses of Liquidity Ratios

Liquidity Ratios provide useful information on the financial health of an enterprise. As per the Financial Accounting Standard Board (FASB) Accounting Standards Codification, an enterprise has certain requirements for liquid assets and a minimum required level of cash flow. If the cash flow is insufficient to meet its liquidity requirements, an enterprise must adjust its financial statements to ensure that it meets its cash requirements.

Liquidity amounts to the availability of assets in cash or near cash form or which could be converted into cash quickly.

Examples of liquid assets involve cash in hand (of course), cash at the bank, inventory (as it can be sold to generate the cash), marketable securities (they are also readily saleable), prepaid expenses etc. Typically banks and different monetary establishments have an interest in knowing the liquidity position of their client business entities. Generally, better liquidity is considered a sign of a sound business position.

There are three sub-categories of liquidity ratios:

A. Current Ratio

The current ratio is often known as the Working Capital Ratio. It establishes the connection between the current ratios and current liabilities. It reveals the business’s ability to satisfy its current liabilities out of current assets. The current ratio is an important ratio for checking the liquidity of a business firm and is considered an indicator of capital adequacy.

The formula of Current Ratio= Current Assets/ Current Liabilities

Instance: Let’s say the corporate present belongings are valued at \$8,000 and the whole present liabilities quantity to \$4,000. Right here, the present ratio will probably be \$8,000/\$4,000 = 2:1

B. Liquid Ratio or Acid Test Ratio

Liquid ratio/acid test ratio/quick ratio are the same things. This ratio establishes the relationship between liquid assets and current liabilities.

Liquid assets refer to these assets which may be converted into money in a short time period. It excludes the stock and prepaid expenses, as stock will take time to sell and collect money whereas the prepaid expenses are usually not going to provide any benefit in cash.

Therefore, liquid assets = current assets – (Stock+prepaid expenses)

Formula of Liquid or Acid Test Ratio= [Current Assets – (Inventory+Prepaid Expenses)]/ Current Liabilities

Example: Continuing with the example used for the current ratio, let’s assume the whole current assets consist of stock worth \$2,000. The liquid ratio will be [8000-2000]/4000 = 1.5:1.

C. Absolute Liquid Ratio

In many countries, it is also known as the Cash Ratio. This ratio establishes the relationship between the cash or near-cash assets to the current liabilities. Here, near-cash assets refer to those assets that are already cash or can be converted into cash quickly, such as bank balance and marketable securities.

Formula of Absolute Liquid Ratio = [Cash+Bank balance + Marketable Securities] / Current Liabilties

Conclusion

The purpose of liquidity ratios is to assist investors and analysts in determining whether a company can meet its short-term financial obligations. A low liquidity ratio may indicate financial distress because it may make it difficult for a company to pay its debts or maintain operations. A high liquidity ratio, on the other hand, suggests that a business may be more financially stable and has sufficient liquid assets to meet its obligations.