Home » What is A Good Liquidity Ratio? Full Guide

What is A Good Liquidity Ratio? Full Guide

The term liquidity ratio might sound like something reserved for business leaders, but it’s crucial for every business owner to comprehend and maintain a healthy liquidity ratio.

If you’re unfamiliar with this concept, fear not.

In this blog, I’ll delve into what it entails and provide you with formulas to calculate and understand this vital financial metric.

What is a Liquidity Ratio?

As complicated as it may sound It is nothing but the ability of a business or company to pay off its debts. 

In other words, a liquidity ratio shows whether a company has enough current assets to cover its liabilities. 

It is very important for a business owner to have complete knowledge of this concept, or else the business may sink under its liabilities.

What is a Good Liquidity Ratio?

Now that you understand the liquidity ratio, let’s determine what’s considered good for your business.

In general, a ratio higher than 1 is deemed favorable, ensuring optimal liquidity for sound financial health.

What If a Company Has a Liquidity Ratio of 1?

It will mean that your assistance completely cancels out your liabilities.

It doesn’t mean that your business is worth investing in because you don’t have any ‘extra’ assets in hand by which you can compensate for unseen circumstances.

Still, some investors ‘may’ consider investing.

What if a Company Has a Liquidity Ratio of Less Than 1?

It means that your liabilities are more than your assets. It is a big red cross for investors.

Why would anyone invest in a business that is sinking in its liabilities?

What if a Company Has a Liquidity Ratio of More Than 1?

Now, this is what investors are looking for.

A business that has more assets compared to its liabilities. 

This attracts investors and increases the value of your business.

So, this is the spot that you should aim for when it comes to the liquidity ratio of a business.

What is a Company That Has a Very High Liquidity Ratio?

Now, this can be a problem.

Having a very high liquidity ratio simply means that you have too much cash in hand and you are not willing to invest that cash in the growth of the company.

This is also a big NO for investors. 

Now that you’re acquainted with the significance of the ratio, let’s explore how to calculate it?

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Formulas To Find Out Liquidity Ratio

Here are some formulas to find out.

Current Ratio

This ratio is also known as working capital and it measures your business’s assets against its liabilities.

Current ratio = current assets/ liabilities.

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Acid-Test Ratio

Also known as the Quick ratio, it shows whether you can pay off your liabilities with your quick assets or not.

Quick assets are assets that can be converted into cash within 90 days.

Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

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Cash Ratio

It shows whether your business is able to pay off its liabilities with its cash or cash equivalents or not.

Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities

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FAQ (Frequently Asked Questions)

I believe after going through this article you get a deep understanding of the topic.

Now here are some commonly asked questions that you might also have in your head.

So, let’s explore them.

(i) What is The Ideal Liquidity Ratio?

A2: 2/1 is an ideal liquidity ratio but it may vary slightly from industry to industry.

(ii) What is a Bad Liquidity Ratio?

A3: Anything less than 1 is considered a bad ratio.

It means that your company has more liabilities than assets.

(iii) What Does a Current Ratio of 1.2 Mean?

A4: It means that the company is not safe to invest in and has 2 times more liabilities than assets.

(iv) What Are The Formulas To Calculate Liquidity Ratios?

A4: Three key formulas include:

Current Ratio: Current assets divided by liabilities.

Acid-Test Ratio (Quick Ratio): (Cash + Marketable Securities + Accounts Receivable) divided by current liabilities.

Cash Ratio: (Cash + Short-Term Investments) divided by current liabilities.

(v) What Does It Mean If a Company Has a Liquidity Ratio of 1?

A3: A liquidity ratio of 1 suggests that a company’s current assets are just enough to cover its liabilities.

While it doesn’t indicate surplus assets, some investors may still consider such a business.

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Conclusion

In summary, grasping the significance of the liquidity ratio is paramount for both business proprietors and investors alike.

For business owners, this metric serves as a compass, offering invaluable guidance in the decision-making process concerning the adjustment of assets and liabilities.

This understanding becomes a strategic cornerstone, empowering owners to fortify their financial standing and resilience against the dynamic backdrop of market fluctuations.

Investors, on the other hand, leverage the ratio as a powerful tool to assess a company’s performance.

This insight becomes a cornerstone for informed investment decisions, aligning their strategies with the financial well-being of the chosen companies.

In essence, the ratio becomes a compass, leading investors towards opportunities that harmonize with the financial health and stability of prospective investments.

Conclusively, the liquidity ratio stands as a pivotal metric, bridging the realms of financial management and investment decisions.

Its significance is underlined by its role in steering businesses and investments through challenges and fostering success amidst the ever-evolving economic landscape.

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Richard Smith

I am Richard Smith from the USA. I’m an Email Marketing Specialist. I have my own blogging site blogest.org. where people will get all Paid Campaigns and Email Marketing and blogging information. I like to encourage and motivate the new youth generation who want to learn Digital Marketing.

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