Liquidity Ratios
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The
liquidity ratios indicate
the extent to which current liabilities can be paid off with cash and other current assets. The balance sheet can be used to calculate the liquidity ratio. Analysts generally use
three liquidity ratios to evaluate companies: Cash Ratio Quick Ratio or Acid Test Ratio, and Current Ratio. As a result, the ratios indicate the level of financial solvency of an organization. In order to calculate liquidity ratios, cash and cash equivalents are compared with current liabilities.
Cash Ratio
The cash ratio is calculated by dividing available cash and cash equivalents by current liabilities. Liquid assets are defined as cash and cash equivalents, excluding receivables, inventories and other current assets. It therefore measures a company's ability to remain solvent in an emergency. Companies that are highly profitable may experience difficulties if they lack the liquidity to respond to unforeseen circumstances. A very high cash ratio would be beneficial from a risk minimization perspective. Nevertheless, a high cash ratio also implies that a significant amount of cash remains unused. In this manner, the available cash is not invested in the company, thereby reducing the return.
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
Quick Ratio
A quick ratio is less restrictive in terms of liquidity than a cash ratio. In the quick ratio (also known as the acid test ratio), inventories and other current assets are excluded since they are less liquid. In order to calculate the ratio, cash and cash equivalents are added to short term investments and account receivables and then divided by current liabilities. Ideally, the quick ratio should be 1, so that all current liabilities can be covered by receivables and liquid assets. Otherwise, there is a risk that receivables will default. A variation of the quick/acid test ratio involves deducting inventories and prepaid costs from current assets and then dividing them by current liabilities.
Quick Ratio = (Cash and Cash Equivalents + Short-Term Investments + Accounts Receivable) / Current Liabilities
Quick Ratio (Variation) = (Current Assets – Inventories – Prepaid Costs)/ Current Liabilities
Current Ratio
In this ratio, a company's current assets are compared to its current liabilities. It is generally considered desirable to maintain a current ratio of 2. In the event that the ratio were 1, a small loss of receivables could already result in financial difficulty.
Current Ratio = Current Assets / Current Liabilities
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