One of the most important financial measures you should know about is the liquidity ratio. This is a simple calculation that compares your cash to your current liabilities. Because it’s a quick way to tell how likely you are to be able to pay your bills if you want to, it’s a good idea to know about this ratio and why it’s important. Considering how important it is, we thought it would be useful to put together a brief discussion on this subject. If you want to learn more about this, read on as we break down everything that you need to know about liquidity ratio.

What Is a Liquidity Ratio?

A liquidity ratio is a type of financial ratio used to determine a company’s ability to pay off its short-term debt with its current assets. Essentially, this is the metric that helps determine if a company can pay its current liabilities with its current assets. There are three liquidity ratios that are commonly used. In each of the ratios, current liabilities are compared to cash and other liquid assets.

What Are the Types of Liquidity Ratios?

To best understand what liquidity ratios are, it’s important that you familiarize yourself with the different types of liquidity ratios. Here are the three types of liquidity ratios:

    1. Current Ratio: As the simplest liquidity ratio, the current ratio is easy to find by simply calculating and interpreting the current assets line item (which is found on the balance sheet) and current liabilities line item (also found on the balance sheet). The current ratio is simply the result of dividing the amount of the current assets by the amount of the current liabilities. The resulting number indicates how many times over (or under) a business has enough cash on hand to pay off its short-term debts.

    2. Quick Ratio: The quick ratio is a stricter test of liquidity than the current ratio. Despite the fact that both are similar in the sense that current assets are the numerator, and current liabilities are the denominator. The main difference is that the quick ratio only considers specific current assets. Quick ratios only consider liquid assets such as cash, accounts receivable, and marketable securities.

    3. Cash Ratio: This type of liquidity ratio only measure of liquidity only considers a company’s most liquid assets – cash and marketable securities. These assets are readily available to a company to meet its short-term obligations.

Why Is It Important to Have a Good Liquidity Ratio?

Liquidity ratios help investors and creditors see whether a company can cover their short-term obligations and to what degree. The closer the ratio is to 1, the better the company’s liquidity situation is. However, a ratio of 1 is not necessarily ideal. Aside from this, having a good liquidity ratio also helps determine your overall creditworthiness. 

To add to this, creditors take liquidity ratios into consideration when deciding whether or not to extend credit to a company. They want to be sure that the company they are lending to has the ability to pay them back. Any hint of financial instability may disqualify a company from obtaining loans.

Conclusion

We hope this article proves to be useful when it comes to helping you further your understanding of your finances. As you can see, your liquidity ratio is something that you’ll want to have a good grasp of due to its ability to impact both your short-term and long-term finances. If you have any more specific questions about this, we recommend reaching out to professional accountants and bookkeepers.

BarettStacey Accounting is a friendly, approachable team of accountants and bookkeepers in Bristol, offering quality financial services to help businesses stay on top of their finances. If you are looking for accounting and bookkeeping services, reach out to us today!