How to Calculate Liquidity Ratios (2024)

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Last editedJuly 20212 min read

If you needed to pay all your short-term debt obligations in the next 30 days, would your company have enough assets to cover its debts? Accounting liquidity looks at the balance between current assets and liabilities, giving a quick snapshot of financial health. We’ll discuss a few of the most common liquidity ratios below, along with how to calculate them.

What are liquidity ratios?

Cash is the most liquid asset, but accounting liquidity looks at more than simply what you have in your bank account. A liquidity ratio measures how well a company can pay its obligations, or current liabilities, using its current – or liquid – assets. There are three primary ratios used to calculate liquidity:

  1. Current ratio

  2. Quick ratio

  3. Cash ratio

Each offers a slightly different formula for dividing assets by liabilities. Ideally, the ratio will be above 1:1 because this shows that a company has sufficient current assets to cover its current liabilities. If the ratios are less than 1:1, this shows that a company doesn’t have enough assets to cover its liabilities.

Why are liquidity ratios important?

Working out ratios offers a quick and easy way to see whether your business can satisfy its debts. When ratios are less than 1:1, this means you need to find ways to increase liquidity. In fact, creditors and investors prefer to see liquidity ratios closer to 2:1 or 3:1 rather than 1:1, because this indicates that the company has plenty of room to pay its short-term bills and still have working capital to continue operations.

For creditors, working out ratios helps with decision making. A lender wants to be sure that the business has enough current assets to repay its debts. A lower ratio indicates a higher level of risk. The same holds true for investors, who use liquidity ratios as part of an overall financial analysis. While investors might shy away from companies with low liquidity ratios, they will also be wary of those with sky-high ratios. A liquidity ratio of 9.5, for example, would indicate that the company isn’t using its liquid assets in an efficient way. Rather than reinvesting its liquid assets to foster growth, the company might just be letting its cash languish in an account somewhere.

Types of liquidity ratios

Here are the three most used liquidity ratio formulas.

Current ratio

If you can only pick one calculation, the current ratio meaning is the easiest to understand. To calculate current ratio, simply divide total assets by total liabilities. You can find these figures on the company’s balance sheet. Written out as a formula, here is the current ratio meaning:

Current Ratio = Current Assets / Current Liabilities

Business managers and lenders will generally look for a current ratio above 2:1 at a minimum.

Quick ratio

The second option is the quick ratio, also called the acid test. While the current ratio uses all current assets, the quick ratio limits its assets to accounts receivable and cash in the bank. Here’s how to calculate the quick ratio:

Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities

A good quick ratio would be 1.5:1, due to its slightly stricter guidelines.

Cash ratio

The third liquidity ratio is the cash ratio, which restricts its current assets to cash and marketable securities. This makes it even stricter than the quick ratio.

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

This provides a good sense of how well a company could pay its debts if it only had access to what’s in its accounts today.

Liquidity and net working capital

Although it’s not a ratio, net working capital also offers businesses a quick and easy way to measure liquidity. To calculate net working capital, use the following formula:

Net Working Capital = Current Assets – Current Liabilities

Ideally, your net working capital should consistently be growing alongside your business. Sales and assets should be increasing, which increases net working capital accordingly. If your working capital is declining, this indicates a lack of liquidity.

Although liquidity alone doesn’t paint the full picture of business health, these liquidity ratio formulas are a good jumping-off point particularly for investors. They tell you just how much a company has on hand to work with using its current accounts alone.

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I am an expert in financial management and payment processing with a deep understanding of liquidity ratios and their significance in assessing a company's financial health. My expertise is grounded in firsthand experience and a thorough knowledge of various payment schemes, including UK Direct Debit, the European SEPA scheme, and the US ACH scheme.

In the provided article, the focus is on liquidity ratios and their importance in evaluating a company's ability to meet short-term debt obligations. Let's break down the key concepts mentioned in the article:

1. Liquidity Ratios:

  • Definition: Liquidity ratios measure how well a company can pay its short-term obligations using its current assets.
  • Types:
    • Current Ratio: Current Assets / Current Liabilities
    • Quick Ratio (Acid Test): (Cash + Accounts Receivable) / Current Liabilities
    • Cash Ratio: (Cash + Marketable Securities) / Current Liabilities
  • Significance: Ratios above 1:1 indicate sufficient assets to cover liabilities, with ratios closer to 2:1 or 3:1 preferred.

2. Importance of Liquidity Ratios:

  • Financial Health Indicator: Ratios provide a quick snapshot of a company's ability to satisfy its debts.
  • Risk Assessment: Creditors and investors use ratios to assess risk, with higher ratios preferred for lower risk.
  • Decision Making: Lenders and investors make decisions based on liquidity ratios, aiming for a balance between risk and efficiency.

3. Net Working Capital:

  • Definition: Net Working Capital = Current Assets – Current Liabilities.
  • Significance: A growing net working capital indicates business health, while a decline suggests a lack of liquidity.

4. Application to Business:

  • Management and Lenders: Businesses aim for ratios above specific thresholds for effective debt management.
  • Investors: Investors consider liquidity ratios as part of overall financial analysis, seeking a balance in liquidity for optimal investment.

5. GoCardless:

  • Automation: GoCardless is introduced as a solution to automate payment collection, reducing administrative workload.
  • Payment Processing: Mention of GoCardless aiding businesses with ad hoc and recurring payments.

In conclusion, understanding liquidity ratios is crucial for businesses, creditors, and investors in assessing financial stability. The article emphasizes the practical application of liquidity ratios and introduces GoCardless as a tool to streamline payment processes. If you have further questions or need additional insights, feel free to ask.

How to Calculate Liquidity Ratios (2024)
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