The term liquidity ratio may seem something for a business head.
But it is very important to know what is the liquidity ratio of your business and it is also important to maintain a good liquidity ratio.
Don’t know what a good liquidity ratio is?
If you are new to this concept then don’t worry because in this blog I will talk in detail about what a liquidity ratio is and will also give you some formulas to find liquidity ratio.
Table of Contents
What is a Liquidity Ratio?
As complicated as it may sound a liquidity ratio 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, else the business may sink under its liabilities.
What is a Good Liquidity Ratio?
So now you know what a liquidity ratio is let us know what is considered as a good liquidity ratio?
Anything higher than 1 is considered a good liquidity ratio.
What if a Company has a Liquidity Ratio of 1?
It will mean that your assist 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 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 know what a liquidity ratio is and what a good liquidity ratio is, let us see how to find out liquidity ratio?
Formulas to Find Out Liquidity Ratio
Here are some formulas to find out the liquidity ratio.
Current Ratio
This ratio is also known as working capital and it measures your business’s assets against its liabilities.
- Current ratio = current assests/ liabilities.
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 the assets that can be converted into cash within 90 days.
- Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
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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Frequently Asked Questions (FAQ) about Liquidity Ratio
Here are some frequently asked questions about the liquidity ratio.
i) What is the ideal liquidity ratio?
2/1 is an ideal liquidity ratio but it may vary slightly from industry to industry.
ii) What is a bad liquidity ratio?
Anything less than 1 is considered a bad liquidity ratio.
It means that your company has more liabilities than assets.
iii) What does a current ratio of 1.2 mean?
It means that the company is not safe to invest in and has 2 times more liabilities than assets.
Parting Words
So this was all about liquidity ratio.
It is important for the owner of the company to know the liquidity ratio of the company because by knowing this they can decrease or increase their assets or liabilities.
An investor should also be familiar with the liquidity ratio so that he can be aware of the company’s performance and then he can invest accordingly.
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