Liquidity Ratios measure the ability of the organization to meet its short-term financial obligations.
Two ratios are commonly used:
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
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.