Liquidity Ratios

Current Ratio

The current ratio is a financial ratio that measures whether a firm has enough resources to pay its debts over the next 12 months.

The liquidity ratio expresses a company's ability to repay short-term creditors out of its total cash. It is the result of dividing the total cash by short-term borrowings. It shows the number of times short-term liabilities are covered by cash. If the value is greater than 1.00, it means they are fully covered. High liquidity means a company can meet its short-term obligations.

Liquidity ratio may refer to:

• Reserve requirements – a bank regulation that sets the minimum reserves each bank must hold.
  
  
• Acid Test - a ratio used to determine the liquidity of a business entity.

The formula is the following:

LR = liquid assets / short-term liabilities

Current Ratio

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm's current assets to its current liabilities. It is expressed as follows:

Current ratio = current assets / current liabilities

• A current asset is an asset on the balance sheet that can either be converted to cash or used to pay current liabilities within 12 months. Typical current assets include cash, cash equivalents, short-term investments, accounts receivable, inventory, and the portion of prepaid liabilities that will be paid within a year.
  
  
• Current liabilities are often understood as all business liabilities that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer.

The current ratio indicates a firm's market liquidity and ability to meet creditor's demands. Acceptable current ratios vary from industry to industry and are generally between 1.5 and three for healthy businesses. If a company's current ratio is in this range, it generally indicates good short-term financial strength.

If current liabilities exceed current assets (the current ratio is below one), the company may have problems meeting its short-term obligations.

If the current ratio is too high, the company may not efficiently use its current assets or short-term financing facilities. This may also indicate problems in working capital management. In such a situation, firms should consider investing excess capital into middle – and long-term objectives.

Low values for the current or quick ratios (values less than 1) indicate that a firm may have difficulty meeting current obligations. However, low values do not indicate a critical problem. If an organization has good long-term prospects, it may be able to borrow against those prospects to meet current obligations.

Some types of businesses usually operate with a current ratio of less than one. For example, if inventory turns over much more rapidly than the accounts payable do, then the current ratio will be less than one. This can allow a firm to operate with a low current ratio.

If all other things were equal, a creditor expecting to be paid in the next 12 months would consider a high current ratio better than a low current ratio. A high current ratio means that the company is more likely to meet its liabilities that fall due in the next 12 months.

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Quick Ratio (Acid-Test Ratio)

The Acid Test or Quick Ratio measures a company's ability to use its assets to retire its current liabilities immediately.

In finance, the Acid Test (also known as the quick ratio or liquid ratio) measures a company's ability to use its near-cash or quick assets to extinguish or retire its current liabilities immediately. Quick assets include current assets that presumably can be quickly converted to cash at close to their book values. A company with a Quick Ratio of less than one cannot pay back its current liabilities.

Quick Ratio = (Cash and cash equivalent + Marketable securities + Accounts receivable) / Current liabilities.

Cash and cash equivalents are the most liquid assets found within the asset portion of a company's balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or Treasury bills, marketable securities, and commercial paper. Cash equivalents are distinguished from other investments through their short-term existence.

They mature within 3 months, whereas short-term investments are 12 months or less, and long-term investments are any investments that mature in excess of 12 months. Another important condition that cash equivalents need to satisfy is the investment should have an insignificant risk of change in value. Thus, common stock cannot be considered a cash equivalent, but preferred stock acquired shortly before its redemption date can be.

Cash Cash is the most liquid asset in a business.

Acid Test Ratio

Acid test often refers to Cash ratio instead of Quick ratio: Acid Test Ratio = (Current assets - Inventory) / Current liabilities.

Note that Inventory is excluded from the sum of assets in the Quick Ratio but included in the Current Ratio. Ratios are viability tests for business entities but do not give a complete picture of the business's health. A business with large Accounts Receivable that won't be paid for a long period (say 120 days), and essential business expenses and Accounts Payable that are due immediately, the Quick Ratio may look healthy when the business could actually run out of cash. In contrast, if the business has negotiated fast payment or cash from customers and long terms from suppliers, it may have a very low Quick Ratio and yet be very healthy.

The acid test ratio should be 1:1 or higher; however, this varies widely depending on the industry. The higher the ratio, the greater the company's liquidity will be (better able to meet current obligations using liquid assets).