Measuring Liquidity

Measuring Liquidity

Understanding Liquidity

• Liquidity refers to the ease with which an asset or security can be converted into cash.
• Financial liquidity represents the company’s ability to pay off its short-term debts as they are due.

Methods to Measure Liquidity

Current Ratio

• A financial metric used to measure a company’s ability to repay short-term liabilities with short-term assets.
• The ratio is calculated as Current Assets / Current Liabilities
• The higher the ratio, the better the position of the company.

Quick Ratio

• Also known as the acid test ratio. It measures a company’s ability to meet its short-term obligations with its most liquid assets.
• It is calculated as (Current Assets - Inventory) / Current Liabilities
• Unlike the current ratio, the quick ratio excludes inventory from current assets.

Cash Ratio

• A measurement of a company’s liquidity, specifically the ratio of company’s total cash and cash equivalents to its current liabilities.
• The metric calculates a company’s ability to repay its short-term debt.
• This is the most stringent and conservative of the three liquidity ratios. It excludes inventory and receivables, focusing only on the immediate cash availability.

Importance of Liquidity

• Ensuring that the business can meet its short-term liabilities as and when they are due.
• Enhancing the business’s credit standing and ability to get finance.
• Reflecting the overall health and profitability of the business.

Limitations of Liquidity Ratios

• They are historical and static, as they are based on information taken from the company’s balance sheet at a specific point in time.
• These ratios also cannot account for unpredictable future events which could impact the company’s liquidity.
• Overemphasis on liquidity could result in maintaining excessive current assets, which might not be optimally used.