Liquidity Ratios

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Liquidity ratios are used to measure the ability of a company to pay its short-term debts using liquid assets which can be converted to cash quickly. In this section, we cover the most important liquidity ratios you need to know.

What are Liquidity Ratios Used For?

Liquidity ratios are metrics that speak of a company’s capacity to cover its financial obligations as soon as they are due. Specifically, these numbers show how many times over short-term liabilities can be paid using the business’ cash and liquid assets. Higher liquidity ratios are generally safer as far as a company’s ability to settle its current liabilities is concerned. Liquidity ratios above 1 show that the business is in a favorable fiscal position and is unlikely to encounter hardships.

Various assets may be considered relevant, depending on the analyst. Some say only cash and cash equivalents count as relevant assets because short-term liabilities will probably be paid in cash. For others, debtors and trade receivables should qualify as relevant, while yet others consider the value of inventory relevant in liquidity ratio calculations.

The cash cycle is another vital concept to study for those who seek a greater understanding of liquidity ratios. Cash normally moves around a company’s operations and is tied up until the inventory is sold and the company receives the payment in cash. But until that payment is made, the money going around in the cash cycle is called working capital, where liquidity ratios are metrics that determine the balance between the company’s current assets and current liabilities.

Before a company can meet its financial obligations, it must first extract cash from the cash cycle so that creditors can be paid. In short, a company should have the capacity to convert its short-term assets into cash. That’s exactly what liquidity ratios attempt to assess.

Liquidity Ratio Pros & Cons

Analysts can rely on liquidity ratios to quickly assess several companies at once for potential issues. They help creditors determine whether or not a company can cover short-term liabilities and the level of risk they carry when seeking new debt. By comparing ratios within a single industry, analysts improve their understanding of a company’s fiscal strength with respect to those of its competitors.

Liquidity ratios, while generally useful, are not perfect metrics. They are calculated using values found in the company’s balance sheet, which means they capture a moment in the past but can’t be taken as a predictor of future performance. They can also be a the outcome of brilliant accounting strategies. A good analyst, however, will not only analyze the numbers themselves, but also every item of the balance sheet under current assets and current liabilities.

The Complete List of Liquidity Ratios

Below is the complete list of liquidity ratios we have covered. Each will provide a detailed overview of the ratio, what it’s used for, and why.

They also explain the formula behind the ratio and provide examples and analysis to help you understand them.

Net Debt

Net debt is a liquidity metric that measures a company’s ability to settle all of its debts should they need to be…

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Inventory to Working Capital Ratio

Inventory to working capital is a liquidity ratio that measures the amount of working capital that is tied up in…

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Cash to Working Capital Ratio

The cash to working capital ratio measures what percentage of the company’s working capital is made up of cash and…

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Cash to Current Assets Ratio

Cash to current assets is a liquidity ratio that measures how much of the current assets in a company are…

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Cash Flow Adequacy Ratio

The cash flow adequacy ratio is used to determine if the cash flow generated by a company is sufficient to…

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Cash to Current Liabilities Ratio

Cash to current liabilities ratio, also known as the cash ratio, is a cash flow measure that compares the firm’s…

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Working Capital to Debt Ratio

The working capital to debt ratio reflects a company’s ability to settle all of its debts using only its working…

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Sales to Current Assets Ratio

The sales to current assets ratio is a measure of how efficiently a company is using its current assets to…

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Sales to Working Capital Ratio

Sales to working capital ratio is a liquidity and activity ratio that shows the amount of sales revenue generated by…

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Average Payment Period (APP)

Average payment period (APP) is a metric that allows a business to see how long it takes on average to…

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Average Inventory Period

Average inventory period refers to a financial ratio used to compute the average number of days a company takes before…

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Defensive Interval Ratio (DIR)

Defensive interval ratio (DIR), also known as the defensive interval period (DIP) or basic defense interval (BDI), determines how many…

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Days Sales Outstanding (DSO)

Days Sales Outstanding (DSO) refers to the average number of days a company takes to collect its payments from the…

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Days Payable Outstanding (DPO)

Days payable outstanding (DPO) is a ratio measuring the average time a company takes to pay its invoices & bills to…

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Z-Score

The Z-score, sometimes referred to as standard score, is a numerical measurement that is used in statistics to find a…

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Working Capital Ratio

The working capital ratio is a liquidity tool that gauges a company’s ability to settle its current debts with its current assets….

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Cash Conversion Cycle (CCC)

The cash conversion cycle (CCC) is a measure of time indicated in days needed to convert inventory investments and other…

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Cash Ratio

The cash ratio (also known as the cash coverage ratio) is a measurement of how well can the company pay…

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Accounts Receivables Turnover

The accounts receivables turnover is a calculation to measure how successful a company is in collecting money owed to them…

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Quick Ratio

The quick ratio, also referred to as the acid test ratio, is a liquidity ratio that measures the ability of…

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Current Ratio

Current ratio determines the ability of a company or business to clear its short-term debts using its current assets. This…

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Net Working Capital

Net working capital is a liquidity ratio which shows whether a company can pay off its current liabilities with its…

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