What are Liquidity Ratios
Liquidity ratios are a class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio and operating cash flow ratio.
Using Liquidity Ratios
BREAKING DOWN Liquidity Ratios
Liquidity ratios are most useful when they are used in comparative form. This analysis may be internal or external. For example, internal analysis regarding liquidity ratios involves using multiple accounting periods that are reported using the same accounting methods. Comparing previous time periods to current operations allows analysts to track changes in the business. In general, a higher liquidity ratio shows a company is more liquid and has better coverage of outstanding debts.
Alternatively, external analysis involves comparing the liquidity ratios of one company to another or an entire industry. This information is useful to compare the company's strategic positioning in relation to its competitors when establishing benchmark goals. Liquidity ratio analysis may not be as effective when looking across industries as various businesses require different financing structures. Liquidity ratio analysis is less effective for comparing businesses of different sizes in different geographical locations.
Solvency vs. Liquidity
Solvency relates to a company's overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current financial accounts. A company must have more total assets than total liabilities to be solvent and more current assets than current liabilities to be liquid. Although solvency does not relate directly to liquidity, liquidity ratios present a preliminary expectation regarding a company's solvency.
Examples of Liquidity Ratios
The most basic liquidity ratio or metric is the calculation of working capital. Working capital is the difference between current assets and current liabilities. If a business has a positive working capital, this indicates it has more current assets than current liabilities and in the event of an emergency, the business can pay all of its short-term debts. A negative working capital indicates that a company is illiquid.
The current ratio divides total current assets by total current liabilities. This ratio provides the most basic analysis regarding the coverage level of current debts by current assets. The quick ratio expands on the current ratio by only including cash, marketable securities and accounts receivable in the numerator. The quick ratio reflects the potential difficulty in selling inventory or prepaid assets in the result of an emergency.