Understanding and Using Liquidity Ratios

Liquidity ratios are commonly used by investors in order to determine how well a company is positioned with its short-term debt obligations. If a company is able to maintain its short-term debt obligations, it is said to have good liquidity ratios. By avoiding companies that have poor ratios, investors can increase the effectiveness of their investments and lower the possibilities of default. Here are a few things to consider about liquidity ratios.

Short-Term Obligations

Liquidity ratios look at the relationship between the liquid assets of a company and the short-term liabilities. If a company can cover its short-term debt, it has good coverage. It is critical for a business to be able to meet its short-term debt obligations. If it cannot meet these obligations, it is only a matter of time before the business will be in default. There are several liquidity ratios that are used by analysts in order to get a good idea of the financial picture of a business. Here are some of the most popular liquidity ratios that are used.

Current Ratio

The current ratio is one of the liquidity ratios most commonly used by analysts. This ratio is calculated by taking the sum of the current assets and dividing it by the sum of the current liabilities. The current assets of the company include the cash, the cash equivalents and the marketable securities. This number can also include the accounts receivables and the inventory on hand, as both of these can be quickly converted into cash. The short-term liabilities could include the notes payable, the current part of term debt, payables, taxes and accrued expenses. This ratio is commonly used with financial statements, but it is not necessarily the best indicator of financial health. This ratio looks at the ability of a company to pay off all of its short-term debt by liquidating a good deal of its assets. This is not a very likely scenario, and if it did occur, it would mean that the company was going out of business. These numbers can be skewed significantly depending on the financial reporting standards of the company.

Quick Ratio

The quick ratio is another ratio commonly used in the analysis of companies. In order to calculate a quick ratio, you can take the cash and equivalents and add to that the short-term investments and accounts receivables. Then you take the total and divide it by the current liabilities. This is a more realistic ratio that makes a lot more sense for most investors. This takes out the inventory and looks at only the other assets of a business.

Cash Ratio

The cash ratio is a liquidity ratio that is also commonly used. In order to calculate this ratio, you take the cash and cash equivalents and add that sum to invested funds. Then you take that and divide it by the current liabilities. This is the most conservative ratio, as it looks only at the cash that a company has on hand and things that can be easily converted into cash.

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