It is used to find the ability of a company that whether they can pay debt or not and it is also used to measure the margin of safety. It is calculated through some metrics which are quick ratio, current ratio and operating ratio. Short term liabilities are compared with current liquid assets to measure the ability of paying short term debts.
Liquidity ratio measures the position of a company’s cash flow, therefore mortgage originators and bankruptcy analysts use this ratio. The usefulness of this ratio can be finding when this ratio is compared. When liquidity ratio is higher it means the company can easily pay its debt and this company is more liquid. Liquidity ratio is used for both external and internal analysis.
Categories of Liquidity Ratios
- Internal Analysis
By internal analysis it means comparing previous accounting periods with current operations.
- External Analysis
And by external analysis means comparison of two companies or comparing one with the entire industry. But liquidity ratio could not be very effective by comparing with the whole industry because every business has different financial structures. It cannot perform accuracy because there is different sizes of businesses and it has different geographic.
Solvency Ratio Vs Liquidity Ratio
Solvency ratio considers overall position of the company’s paying ability of its debt by comparing total assets with the total liabilities and current assets with current liabilities. A company is considered solvent when it has more assets than liabilities, while Liquidity ratio considers only current assets to check its debt paying ability or liquidity.
The Most common Liquidity Ratios
Working capital is mostly used to calculate liquidity ratio. The difference of current liabilities and current assets is called working capital. If the working capital of any business is positive then it means that the business has more current assets comparatively to its current liabilities. And in case of any emergency the company can clear all of their short term debts.
The second mostly used ratio is Current ratio. It can be find through dividing total current assets by total current liabilities. But the current assets only have account receivables, cash and marketable securities.
Quick ratio is measured through dividing (cash, cash equivalents, account receivables and short term investments) by current liabilities. If the business has 1 quick ratio it means they pay all of their short term debts without selling their long term debts.