Liquidity ratios measure a company’s ability to meet its short-term financial obligations. These ratios provide insights into whether a business has enough liquid assets (like cash or easily convertible assets) to cover its liabilities due within a year. Here are the most commonly used liquidity ratios:

1. Current Ratio

The current ratio assesses a company’s ability to pay off its current liabilities using its current assets. It’s calculated using the formula:

Current Ratio=Current Assets/Current Liabilities

A current ratio of 1 or higher is generally considered healthy, as it indicates the company has enough assets to cover its short-term obligations. However, too high a ratio might indicate inefficient use of assets.

Example:

If a company has current assets of ₹1,00,000 and current liabilities of ₹50,000, the current ratio would be:

1,00,000/50,000=2

This means the company has ₹2 in current assets for every ₹1 in current liabilities, suggesting a strong liquidity position.

2. Quick Ratio (Acid-Test Ratio)

The quick ratio is a more stringent measure of liquidity than the current ratio because it excludes inventory from current assets. Inventory is excluded because it may not be as quickly convertible into cash. The formula is:

Quick Ratio=(Current Assets−Inventory)/Current Liabilities

A quick ratio of 1 or more is generally seen as good, meaning the company can pay its current liabilities without relying on selling inventory.

Example:

If a company has current assets of ₹1,00,000, inventory worth ₹30,000, and current liabilities of ₹50,000, the quick ratio would be:

(1,00,000−30,000)/50,000=1.4

This means the company has ₹1.40 in quick assets for every ₹1 of current liabilities.

3. Cash Ratio

The cash ratio is the most conservative liquidity ratio as it considers only cash and cash equivalents (like marketable securities). The formula is:

Cash Ratio=Cash and Cash Equivalents/Current Liabilities

A cash ratio greater than 1 is rare and indicates that the company has more than enough cash to cover its short-term liabilities without selling any assets.

Example:

If a company has ₹20,000 in cash and cash equivalents and ₹50,000 in current liabilities, the cash ratio would be:

20,000/50,000=0.4

This means the company has ₹0.40 in cash for every ₹1 in current liabilities, which is less liquid but not uncommon.

4. Operating Cash Flow Ratio

The operating cash flow ratio measures how well a company can cover its current liabilities using cash generated from operations, reflecting the actual liquidity from day-to-day operations. The formula is:

Operating Cash Flow Ratio=Operating Cash Flow/Current Liabilities

A higher ratio indicates a better ability to cover liabilities from operating cash flows.

Example:

If a company has an operating cash flow of ₹70,000 and current liabilities of ₹50,000, the operating cash flow ratio would be:

70,000/50,000=1.4

This means the company generates ₹1.40 from operations for every ₹1 of current liabilities, indicating a strong liquidity position from core business activities.

Importance of Liquidity Ratios

• Financial health: High liquidity ratios suggest the company can easily meet its short-term obligations.
• Creditworthiness: Lenders and creditors often assess liquidity ratios to gauge a company’s ability to repay short-term debt.
• Operational efficiency: A balance between high liquidity (too much idle cash) and operational efficiency is crucial for better asset utilization.

These ratios provide valuable insights, but they should be considered alongside other metrics for a complete financial assessment.

Read more: Comprehensive Overview of Financial Ratios: Types, Formulas, and Interpretations