Liquidity Ratio - Meaning, Formula, Types

Liquidity refers to the company's ability to meet its short-term obligations and convert its assets into cash quickly. Maintaining adequate liquidity is vital for the smooth functioning of operations, as it enables companies to cover expenses on a timely basis. To measure a company’s liquidity we use liquidity ratios. In this article, learn about liquidity ratios, their types, benefits, and how it is different from solvency ratios.    

What Are Liquidity Ratios?

The liquidity ratio measures the company’s ability to convert its assets to meet immediate debt requirements. The higher the liquidity ratio, the easier it is for the company to clear its short-term dues. The liquidity ratio is one of the key parameters any lender checks while offering loans to a company.   

Types of Liquidity Ratios

There are different types of liquidity ratios. Here are the four commonly used liquidity ratios.  

1. Current Ratio

   This refers to the company’s ability to clear its current liabilities with its current assets like cash, inventories, accounts receivable, etc. The current liabilities are the ones that need to be cleared within a year. If the current ratio is high, it means that the company’s liquidity position is better.

   Current Ratio = Current Assets / Current Liabilities

2. Quick Ratio

   Quick ratio is also known as the acid test ratio. It measures the company’s ability to clear its short-term debts with its most liquid current assets. Here inventories and prepaid expenses are not included. The higher the ratio, the better it is.

   Quick Ratio = (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities

3. Cash Ratio
   

   This ratio measures the company’s ability to pay off its short-term obligations by utilising liquid assets like cash and cash equivalents. If the ratio is high, it means that the company has a good amount of cash to clear the debts.
   Cash Ratio = Cash and Cash Equivalent / Current Liabilities

4. Net Working Capital Ratio
   

   This ratio determines the company’s ability to continue its operations using sufficient cash or funds available. The high ratio indicates that the company is doing well in terms of its current assets.
   Net Working Capital Ratio = Current Assets – Current Liabilities

What Is the Liquidity Ratio Formula?

There are different types of liquidity ratios and each one has a different formula. Here’s a table to list down the liquidity ratios formula. 

Example of Liquidity Ratios

Let us understand the liquidity ratios better with an example. Here is the balance sheet of XYZ Company. Let’s calculate the liquidity ratios of this company. 

Assets 

• • Cash - Rs. 50 million
• • Marketable securities - Rs. 25 million
• • Accounts receivable - Rs. 100 million
• • Inventory - Rs. 80 million
• • Prepaid expenses - Rs. 60 million 

Total current assets = Rs. 315 million

Liabilities 

• • Current liabilities - Rs. 80 million
• • Long-term debt - Rs. 150 million
• • Retained earnings - Rs. 35 million
• • Total equity - Rs. 200 million

Total liabilities = Rs. 465 million

Now let’s calculate the liquidity ratios from this balance sheet of the XYZ Company. 

• • Current ratio = 315/80 = 3.9
• • Quick ratio = (50 + 80 + 25)/80 = 1.9  
• • Cash ratio = (50 + 25)/80 = 0.94
• • Net working capital ratio = 315 - 80 = 235

Benefits of Liquidity Ratios

• • Helps in assessing a company's financial health and solvency by evaluating its ability to meet short-term obligations.
• • Helps in understanding the risk position of a company. 

Solvency Ratios vs Liquidity Ratios

Solvency ratios and liquidity ratios are both financial ratios used to assess different aspects of a company's financial health. Here's a table to understand the difference between solvency ratios and liquidity ratios. 

Conclusion

Liquidity ratios provide valuable insights into a company's short-term financial strength, risk profile, and cash management capabilities. These details can help you in making an informed investment decision. Before analysing a company, understanding your investment objectives and risk appetite is important. Get started with your investment journey only after a thorough understanding of the markets, industry and the company. Before all that, open a Demat Account for free with Angel One.  

Explore the Share Market Prices Today