What is Liquidity Ratio?

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Definition

Liquidity Ratio also referred to as short-term ratio. This ratio helps to understand the liquidity of a business to meet the current obligations without raising external capital. Liquidity ratio helps to measure the ability to pay obligation and measure the margin of safety through the calculation of current ratio, quick ratio and operating cash flow ratio.

“Liquid” assets means the assets which can be converted into cash quickly and cheaply such as Receivable, stock and store etc.

 

Common Liquidity Ratios

Liquidity ratio also expresses the relationship between current assets and current liabilities of the business during a particular period.
Sl No.        Ratio     FormulaRemarks
1.00Current Ratio Current Assets/Current Liabilities2:1
2.00Quick RatioQuick Assets/ Current Liabilities, or Quick Liabilities1:1
3.00Stock Turnover Ratio Cost of Sales/Average InventoryAvg. Inventory = (Opening Inventory+Closing Inventory)/2
4.00Debtors Turnover ratioCredit Sales/Average DebtorsAverage Debtors = (Opening Debtor+Closing Debtor)/2
5.00Creditors Turnover RatioCredit Purchase/Average Accounts PayablesAverage Accounts Payables = (Opening AP+Closing AP)/2

 

AP=Accounts Payables

6.00Working Capital Turnover RatioSales/Net Working CapitalWorking Capital = (Current Assets – Current Liabilities)

Quick assets are the more liquid types of Currents assets which include: Cash and Cash Equivalents, Marketable Securities, and Short Term Receivable. Inventories and Prepayments are not included in Quick Assets.

Hence, Quick ratio = (Current Assets – Inventories-Prepayments) / Current Liabilities.

Liquidity Ratio measures not only the cash a business has. It also measures how easy for the company to raise enough cash or converts assets into cash.. Assets like accounts receivable, trading securities, and inventory are relatively easy for many companies to convert into cash in the short term. Thus, all of these assets go into the liquidity calculation of a company.

Common Example of Liquid Assets

The common example of liquid assets are as follows:

  • Cash in Hand
  • Cash at bank
  • Marketable Securities
  • Inventory
  • Government Bonds
  • Account Receivable
  • Certification of deposits
  • Tax refunds etc.