Evaluate how well a company can pay its short-term debts using liquid assets
Download the free financial ratio ebook and find out which seven ratios to use to evaluate the liquidity of any business.
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?
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.
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.
- A Quick Glimpse at Stockholders’ EquityShareholders’ or Stockholders’ equity is the amount you get when you deduct from the assets on hand to shareholders all paid liabilities of the company.
- ACCA vs CIMAWhether you are in the accounting industry or are aspiring to become an accountant, a professional certification can improve your job prospects and earning potential.
- Accounting Ledger FormatAccounts are simply records of any transaction that has increased or decreased the total balance of an asset, liability or equity item.
- Accounting TransactionsAny transaction event that impacts your business’ finances is termed as an accounting transaction.
- Accounting Transactions in a NutshellA transaction, per se, is the exchange of services or goods between two groups, people or entities.
- Accounting WorksheetAn accounting worksheet is a tool used to determine the accuracy of the financial statements prepared by a company at the end of the accounting period.
- Accounts Payable Turnover Excel TemplateThis accounts payable turnover Excel template lets you quickly calculate the accounts payable turnover ratio and measure the number of times a company pays its suppliers in one year.
- Accounts Payable Turnover RatioAccounts payable turnover ratio (APTR) is a financial ratio of the net credit purchases of a business to its average accounts payable for one year.
- Accounts Receivables TurnoverThe accounts receivables turnover is a calculation to measure how successful a company is in collecting money owed to them from customers.
- Accrual PrincipleThe accrual principle is a very important concept in accounting, and it forms the basis of making adjusting entries during the accounting cycle, which we have covered before.
- Accrued IncomeWhen you invest, earn returns on your investments, but haven’t received the returns yet, you have an accrued income.
- Accumulated Depreciation to Fixed Assets RatioThe accumulated depreciation to fixed assets ratio is a measurement to compare the amount of depreciation for a physical asset with its total value.
- Ad HocDefinition of Ad Hoc Ad Hoc is a word that originally comes from Latin and means “for this” or “for this situation”.
- Adjusted Gross IncomeAdjusted Gross Income (AGI) is the measure of an individual’s taxable income.
- Adjusted Trial BalanceAn adjusted trial balance is a report in which all debit and credit company accounts are listed as they will appear on the financial statements after making adjusting entries.
- Adjusting EntriesAdjusting entries are journal entries (which is why they are sometimes called adjusting journal entries) that are made at the end of the financial reporting period to correct the accounts for the preparation of financial statements.
- Annual IncomeDefinition: Income is money (or some equivalent value) that an individual or business gets, usually in exchange through investing capital or providing a good or service.
- Annual Percentage YieldThe annual percentage yield (APY) helps a business or investor to understand how much they are earning from the money they have invested with compounded interest.
- Annuity PaymentAn annuity is a financial product that pays out a series of cash flows at a specified frequency and over a fixed time period.
- Annuity Payment from Future Value (FV)Annuity payment from future value is a formula that helps one to determine the value of cash flows in an annuity when the future value of the annuity is known.
- Asset AccountsAn asset account is a category within a company’s general ledger account that shows the value of the assets it owns.
- Asset Coverage RatioThe asset coverage ratio determines a company’s capacity to pay its debt through its assets.
- Asset PurchaseWhen a business undertakes an asset purchase, in reality, it just taking this approach to structure the acquisition of a company.
- Asset Purchase AgreementAsset purchase refers to the process involved in the buying of a company’s assets.
- Asset TurnoverThe asset turnover ratio is a way to measure the value of a company’s sales compared to the value of the company’s assets.
- AVCO MethodThe Average Cost Method, also commonly referred to as the AVCO method, is a method used to find the average cost of items recorded in an inventory.
- Average Collection PeriodThe average collection period is an estimation of the average time period needed for a business to receive payment for money owed to them.
- Average Inventory PeriodAverage inventory period refers to a financial ratio used to compute the average number of days a company takes before they sell all their current stock of inventory.
- Average Payment Period (APP)Average payment period (APP) is a metric that allows a business to see how long it takes on average to pay its vendors.
- Balance SheetThe balance sheet is one of the general-purpose financial statements prepared during the accounting cycle.
- Best Accounting CertificationsWhether you are currently an accounting professional or an accounting student, you should consider the impact that a professional certification can have on your career.
- Best Corporate Finance CoursesNo matter where you are in your financial career, building on your knowledge and skills is always worth the journey.
- Best Financial CalculatorOver the years we have received many questions from students looking for the best financial calculator to help them with their finance/accounting classes and certification exams like the CFP or the CFA.
- Best Financial Management Courses
- Bond Equivalent YieldBond equivalent yield (BEY) is a rate that helps an investor determine the annual yield of a bond (or any other fixed-income security), that does not provide an annual payout.
- Bond Value Excel TemplateThis bond pricing Excel template can help you with the following: Bond pricing Bond Valuation Bond Yield For more analysis, see our present value article (a commonly used metric in bond pricing).
- Book Value Per ShareBook value per share (BVPS) is the minimum cash value of a company and its equity.
- Break-Even Point AnalysisBreak-even point analysis examines how much a company can safely stand to lose before descending below its break-even point.
- Break-Even Point Analysis Excel TemplateBreak-even point analysis examines how much a company can safely stand to lose before descending below its break-even point.
- BudgetA budget is a formal statement of estimated revenue and expenses over a specific period in the future, based on their objectives.
- Business Entity ConceptThe business entity assumption is an accounting principle that makes a legal distinction between the transactions carried out by a business and the transactions of the owner.
- Business EventsA business event is a business transaction in which there is an exchange of value between two groups.
- Business OwnerA business owner is an individual or an entity who owns and operates a business.
- Capital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) provides a way to calculate the expected return of an investment based on the time value of money and the systematic risk of the asset.
- Capital Asset Pricing Model (CAPM) Excel TemplateThe Capital Asset Pricing Model (CAPM) provides a way to calculate the expected return of an investment based on the time value of money and the systematic risk of the asset.
- Capital BudgetingIt was pointed out in the valuation of corporate securities overview that the value of an asset, whether financial or real, depends on the discounted value of cash flows over a relevant time horizon.
- Capital Gains YieldA capital gains yield is the rise in the price of a security, like common stock, over a given period of time.
- Capital Intensity RatioCapital intensity ratio (CIR) is a metric that shows you how much capital is needed to generate $1 of revenue.
- Capital Lease AccountingCapital lease accounting refers to the accounting treatment of assets leased by a business under a capital lease agreement.
- Capital ResourcesCapital resources are the man-made assets employed in the manufacturing of further goods.
- Capitalization RatioThe capitalization ratio, also referred to as the cap ratio, is an indicator that measures the ratio between a company’s debts within its capital structure—the combination of debts and equities.
- Cash Conversion Cycle (CCC)The cash conversion cycle (CCC) is a measure of time indicated in days needed to convert inventory investments and other resources into sales-derived cash flow.
- Cash Earnings Per Share (Cash EPS)Cash earnings per share (Cash EPS) is a profitability ratio that compares a company’s cash flow against their volume of shares outstanding.
- Cash Flow Adequacy RatioThe cash flow adequacy ratio is used to determine if the cash flow generated by a company is sufficient to pay for its ongoing expenses—for example, reductions in long-term debt, acquisition of fixed assets or paying dividends to shareholders.
- Cash Flow Coverage RatioThe cash flow coverage ratio represents the relationship between a company’s operating cash flow and its total debt.
- Cash Flow Statement – Direct MethodA statement of cash flows can be prepared by either using a direct method or an indirect method.
- Cash Flow Statement – Indirect MethodA statement of cash flows can be prepared by either using a direct method or an indirect method.
- Cash Flow to Debt RatioThe cash flow to debt ratio is a coverage ratio that reflects the relationship between a company’s operational cash flow and its total debt.
- Cash Flow to Sales RatioCash Flow to Sales Ratio is a performance metric that represents a business’s operating cash flow once all capital expenditures related to sales have been deducted.
- Cash RatioThe cash ratio (also known as the cash coverage ratio) is a measurement of how well can the company pay its short-term debt in the form of cash and cash equivalent (investment items that immediately available to be turned into cash e.
- Cash Reinvestment RatioThe cash reinvestment ratio, also known as the cash flow reinvestment ratio, is a valuation ratio used to measure the percentage of annual cash flow that the company invests back into the business as a new investment.
- Cash Return On Assets RatioThe cash return on assets (cash ROA) ratio is a measure of the operational cash flow against the total assets owned by a business.
- Cash SalesA cash sale is a business transaction in which the buyer pays for goods or services at the time of the purchase.
- Cash to Current Assets RatioCash to current assets is a liquidity ratio that measures how much of the current assets in a company are made up of cash and cash equivalents.
- Cash to Current Liabilities RatioCash to current liabilities ratio, also known as the cash ratio, is a cash flow measure that compares the firm’s most liquid assets to its short-term obligations.
- Cash to Working Capital RatioThe cash to working capital ratio measures what percentage of the company’s working capital is made up of cash and cash equivalents such as marketable securities.
- Cash Turnover Ratio (CTR)The cash turnover ratio (CTR) a profitability and efficiency ratio that measures how many times a company uses its cash to generate revenues.
- CFA Exam CostsThere are so many good reasons to become a Chartered Financial Analyst.
- CFA RequirementsChartered Financial Analyst (CFA), a designation granted by the CFA Institute, is one of the most sought after professional credentials in the world of finance.
- CFA SalaryGetting a new or additional credential after starting after your career is a big decision and usually influenced by two things.
- Chart of AccountsThe chart of accounts refers to the directory of every account made in the general ledger in an accounting system.
- Classified Balance SheetA classified balance sheet is a financial statement that reports the assets, liabilities and equity of a company.
- Closing EntriesClosing entries are manual journal entries at the end of an accounting cycle to close out all the temporary accounts and shift their balances to permanent accounts.
- CompetitionDefinition of Competition Competition is a situation in which someone is trying to win something or be more successful than someone else.
- Completed Contract MethodReporting income or expenses can be postponed using an accounting technique known as the complete contract method.
- Compound Annual Growth Rate (CAGR)Compound annual growth rate (CAGR) is the metric that allows an investor to compare the return rates of their investments over a given time period.
- Conservatism PrincipleThe conservatism or prudence principle in accounting is the general concept of recognizing expenses and liabilities as soon as possible when there is uncertainty.
- Consistency PrincipleThe consistency principle states that once a company adopts a certain accounting policy or method, it must be applied consistently in the future as well.
- ConsumptionConsumption flow and expenditure can be crucial to understand the fluctuations in the different business cycles.
- Continuous CompoundingContinuous compounding is the mathematical limit reached by compound interest when it’s calculated and reinvested to an account balance over a theoretically endless number of periods.
- Contra AccountsA contra account is a general ledger account with a balance that is the opposite of another, related account that it is paired with.
- Contract for Difference (CFD)A contract for difference, often abbreviated to CFD, is an alternative means by which an individual can invest in a company or asset.
- Contribution MarginThe contribution margin measures the difference between the sales price of a product and the variable costs per unit.
- CorporationDefinition of Corporation A corporation is a legal entity that is separate and distinct from its owners or stockholders.
- Correlation CoefficientThe correlation coefficient, also called the Pearson correlation, is a metric that reflects the relationship between two numbers.
- Cost Benefit PrincipleThe cost benefit principle states that the cost of providing the information in the financial statements should not exceed the benefits that the users get from reading those statements.
- Cost Leadership StrategyStrategic planning can take any organization to its pinnacle.
- Cost of Goods Manufactured (COGM) Excel TemplateThe cost of goods manufactured (COGM) is a managerial accounting term that is used to show the total production costs for a specific time period.
- Cost of Goods Sold (COGS)Cost of goods sold (COGS) is the total value of direct costs related to producing goods sold by a business.
- CPA Exam Application ProcessIf you’ve decided to pursue the Certified Public Accountant (CPA) credential, you need to understand how to apply, schedule, and take the exam.
- CPA Exam RequirementsTo become a Certified Public Accountant, commonly referred to as a CPA, there are several requirements you must meet depending upon the state or territory that you plan to become certified in.
- CPA Exam SectionsIf you are planning on pursuing a Certified Public Accountant license, commonly known as a CPA, you will need to pass the Uniformed CPA Exam.
- CPA vs MBA: Which is Better?Whether you are a college student planning out your career track or a seasoned professional seeking to elevate their position, a CPA or MBA may be a good option for your future.
- Credit SalesA credit sale is a type of transaction where the buyer delays payment to a later date.
- Crossover RateCrossover rate is the cost of capital where two projects have the same net present values (NPV) or where their NPV profiles intersect.
- Current RatioCurrent ratio determines the ability of a company or business to clear its short-term debts using its current assets.
- Current YieldThe current yield is the return that an investor would receive, based on a current rate.
- Customer SatisfactionIn comparison to any marketing technique, “word-of-mouth” is still the cost efficient and effective marketing technique.
- Days Cash on HandDays cash on hand is the number of days a company can keep up with its operating expenses using the cash available in the business.
- Days Payable Outstanding (DPO)Days payable outstanding (DPO) is a ratio measuring the average time a company takes to pay its invoices & bills to suppliers and vendors.
Advantages and disadvantages
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.