What is Liquidity Ratio?
What is Liquidity Ratio
Liquidity ratio acts as a financial indicator which helps to analyze the ability of a company to convert its assets into cash so as to pay off its obligations.
A company is valued on the basis of the total assets it owns or the sum of total amount of liability and shareholders’ equity it holds.
An asset of a company, are the resources or a valuable thing which helps the company in the business process to generate revenue and thus create profit for the firm. An asset can be counted as cash, technology, machinery, buildings, inventories, brand value etc.
A liability to a firm is the total amount of debt or borrowings for which it is obliged to payback and thus is used by a firm to run its business operations, buy assets etc.
Shareholders equity is the total amount of money invested in the company by the owners to create value for the firm.
Liquidity ratios are mathematical formulas or financial terms which can help to realize whether a company is able to convert its assets so as to payback its financial short-term debts or obligations within a designed period of 12 months.
There are 2 methods to calculate a liquidity ratio
- Current Ratio
Current ratio is the relationship between current assets to current liabilities
Current Ratio = current assets / current liabilities
Where current assets can be expressed as a resource which can be easily converted to cash within a period of 12 months and current liabilities are the obligations a company needs to pay back within a period of 12 months.
- Quick Ratio
The quick ratio is a total amount of the most liquidate assets such as cash, accounts receivable, marketable securities etc. which a company owns and can use to pay back its current liabilities.
Quick Ratio = (Most liquidable assets) / Current liabilities.
Both the above methods can be used by analyst be to realize the quick ratio of a firm.