## Liquidity Ratios

After reading this section, you will have been exposed to the different types of liquidity ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.

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.

#### LEARNING OBJECTIVE

• Use a company's current ratio to evaluate its short-term financial strength

#### KEY POINTS

• The liquidity ratio expresses a company's ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings.
• 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.
• Current ratio = current assets / current liabilities.
• Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses.

#### TERMS

• current ratio

current assets divided by current liabilities

• working capital management

Decisions relating to working capital and short term financing are referred to as working capital management [19]. These involve managing the relationship between a firm's short-term assets and its short-term liabilities.

#### Liquidity Ratio

Liquidity ratio expresses a company's ability to repay short-term creditors out of its total cash. The liquidity ratio 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 it is fully covered .

Liquidity: High liquidity means a company has the ability to meet its short-term obligations.

Liquidity ratio may refer to:

• Reserve requirement - 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

• 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 liabilities of the business 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 is an indication of 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 3 for healthy businesses. If a company's current ratio is in this range, then it generally indicates good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets or its 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 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, who is expecting to be paid in the next 12 months, would consider a high current ratio to be better than a low current ratio. A high current ratio means that the company is more likely to meet its liabilities which fall due in the next 12 months.

Source: Boundless