Table of Contents
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?
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.
Formulas To Find Out Liquidity Ratio
Here are some formulas to find out.
This ratio is also known as working capital and it measures your business’s assets against its liabilities.
Current ratio = current assets/ liabilities.
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
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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