Loading the player...

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.

Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency.

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.

RELATED TERMS
  1. Quick Liquidity Ratio

    Quick liquidity ratio is the total amount of a company’s quick ...
  2. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained ...
  3. Liquidity

    Liquidity is the degree to which an asset or security can be ...
  4. Liquid Asset

    A liquid asset is an asset that can be converted into cash quickly ...
  5. Accounting Ratio

    Accounting ratios, also known as financial ratios, are used to ...
  6. Asset Coverage Ratio

    The asset coverage ratio determines a company's ability to cover ...
Related Articles
  1. Investing

    Understanding financial liquidity

    Financial liquidity comes into play for companies, your personal finances, investing, and the financial markets. However, assets and investments have varying liquidity levels.
  2. Investing

    Liquidity Measurement Ratios

    Learn about the current ratio, quick ratio, cash ratio and cash conversion cycle.
  3. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  4. Investing

    Useful Balance Sheet Metrics

    These metrics can help you better understand the information found on balance sheets.
  5. Investing

    Key Financial Ratios for Retail Companies

    Using the following liquidity, profitability and debt ratios, an investor can gather deeper knowledge of a retail company's short-term and long-term outlook.
  6. Investing

    6 Basic Financial Ratios And What They Reveal

    These formulas can help you pick better stocks for your portfolio once you learn how to use them.
  7. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  8. Investing

    Understanding Liquidity Risk

    Make sure that your trades are safe by learning how to measure the liquidity risk.
RELATED FAQS
  1. How can a company quickly increase its liquidity ratio?

    Discover what high and low values in the liquidity ratio mean and what steps companies can take to improve liquidity ratios ... Read Answer >>
  2. How do the current ratio and quick ratio differ?

    The current ratio and the quick ratio are both liquidity ratios that measure how a company's ability to pay off its short-liabilities ... Read Answer >>
  3. Is there a downside to having a high liquidity ratio?

    Find out why it might be disadvantageous for a company to have liquidity ratios that are too high, and learn how to find ... Read Answer >>
  4. What is the formula for calculating the current ratio?

    Find out what makes up the current ratio, how to calculate it, and what the result can tell you about a potential investment. Read Answer >>
  5. Differences between liquidity and liquid assets

    Liquid assets can easily be converted into cash. Liquidity is the ability of a business to pay its debts using its liquid ... Read Answer >>
  6. What are liquid assets, and why are they beneficial to a business?

    Learn the difference between liquid and fixed assets, and how a company's liquidity affects its financial health. Read Answer >>
Trading Center