Introduction:
In accounting and finance, a liquid asset means how easily an asset can be converted into cash without losing its original value. Therefore, if we look at the financial statements, we will review the balance sheet. In the balance sheet, a section of assets orders the account groups in order of liquidity. In this post, we will discuss two of the widely used liquidity financial ratios.
Liquidity Financial Ratios:
What is the purpose of liquidity ratios? These ratios show the ability of your business to meet its obligations. In other words, how well you can pay current debts or obligations. Therefore, we need to identify what to use in the financial statements. First, current assets: in the balance sheet, look for cash, cash equivalents, accounts receivable, and inventories. Then, for current liabilities, in the balance sheet, look for accounts payable, trade payable, short-term note payable, accrued taxes, and other accrued expenses.
Current ratio = current assets / current liabilities
The current ratio represents a liquidity measure used to evaluate a business’s ability to pay its current debt. Look at this ratio as a coverage or solvency measure. For example, having a company with current assets totaling $800 thousand and current liabilities totaling $1 million results in a 0.80 current ratio ($800 / $1,000 = 0.80, no dollar sign). This result shows that this company has $0.80 per $1 debt. A second example: having a company with current assets totaling $800 thousand and current liabilities totaling $600 thousand results in a 1.33 current ratio ($800 / $600 = 1.33, no dollar sign). This result shows that this company has $1.33 per $1 debt.
Comparing these two businesses, the second has a better position to pay its short-term debts in case problems arise. Keep in mind that difficulties tend to slow down businesses’ payments. In addition, if examples one and two represent the same company in two different years, moving from a 0.80 to 1.33 ratio is a sign that the business is bettering its short-term position concerning debt payments.
Quick ratio = (current assets – inventories) / current liabilities
The current ratio by itself might not provide useful information because there are certain businesses that have large quantities of inventories. In the current assets, inventories represent the least liquid of assets. Thus, the quick ratio analyzes the business’s ability to pay its short-term debts by eliminating the weight or effect of inventories. This is true because sometimes inventories are difficult to sell in emergencies.
Same example: our company has current assets totaling $800 thousand, including inventories of $300 thousand, and current liabilities totaling $1 million, resulting in a 0.50 quick ratio ($800 – 300) / $1,000 = 0.50 (no dollar sign). This result shows that this company has $0.50 per $1 debt. Second example: having a company with current assets totaling $800 thousand, including inventories of $300 thousand, and current liabilities totaling $600 thousand results in a 0.83 quick ratio (($800 – 300) / $600 = 0.83, no dollar sign). This result shows that this company has $0.83 per $1 debt.
Although we thought we could pay short-term debts just with current assets, part of it depends heavily on inventories. In some situations, inventories do not convert into cash easily; thus, the quick ratio is a better measure than the current ratio.
Conclusion:
Ratio analysis shows the relationships between financial statement accounts. The idea is to analyze multiple years within the business and with other businesses to gain knowledge. A common measure of solvency is the liquidity ratio, the current and quick ratios. Liquidity ratios aid us in measuring the short-term ability of the business to meet its short-term debts.
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