Liquidity ratios are financial metrics that assess a company’s ability to meet its short-term financial obligations using its current assets.
Primary Implication
Should you seek outside financing, know that creditors will use Liquidity Ratios to measure your ability to meet your short-term obligations.
The results of their calculations will tell them how well you could turn liquid assets into cash to pay off liabilities and other current obligations. You will have difficulty securing outside financing if they see Current Liabilities close to Current Assets.
Overview
Using Liquidity Ratios to Make Informed Decisions
What are Liquidity Ratios?
Liquidity ratios are a key measure of a company’s financial health. They tell you how easily a company can meet its short-term financial obligations using its liquid assets (assets that can be quickly converted to cash).
Think of it like this: liquidity ratios show whether a company has enough cash on hand to pay its bills as they come due.
Why are Liquidity Ratios Important?
- Creditors: Lenders use liquidity ratios to assess a borrower’s ability to repay debts.
- Investors: Investors use them to evaluate a company’s financial stability and risk.
- Management: Companies use liquidity ratios to monitor their own financial health and make informed decisions.
Common Liquidity Ratios:
Here are some of the most frequently used liquidity ratios:
- Working Capital or Current Ratio: Measures a company’s ability to pay off its current liabilities with its current assets.
- Quick Ratio: Similar to the current ratio, but excludes inventory (which can be harder to convert to cash quickly).
- Cash Ratio: The most conservative measure, focusing only on the company’s most liquid assets (cash and cash equivalents).
- Accounts Payable Turnover: Measures how quickly a company pays its suppliers.
- Times Interest Earned Ratio: Shows a company’s ability to cover its interest expenses with its earnings.
How are Liquidity Ratios Used?
These ratios help assess a company’s ability to:
- Pay off short-term debts.
- Cover day-to-day expenses.
- Respond to unexpected financial needs.