Liquidity Ratios

Liquidity Ratios measure the ability of the organization to meet its short-term financial obligations.

Two ratios are commonly used:

  1. Current ratio or Working capital ratio = Current assets ÷ current liabilities

  • The current ratio is a liquidity ratio that measures a company’s ability to pay short-term and long-term obligations.
  • A very high current ratio is not necessarily good. It could indicate that a company is too liquid or the company is not making sufficient use of cheap short-term finance.
  • Normally this ratio should exceed 2:1 for a company to be able to safely meet its liabilities
  1. Acid test or Quick ratio = (current assets – inventory) ÷ current liabilities

  • Inventory often takes a long time to convert into cash hence it is deducted from current assets
  • A company with a quick ratio of less than 1 cannot currently fully pay back its current liabilities.

 

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