Liquidity Ratios

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.

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  • Asset Accounts
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  • Asset Coverage Ratio
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  • Asset Turnover
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  • Average Collection Period
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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 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.
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  • Capitalization Ratio
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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 resources into sales-derived cash flow.
  • Cash Earnings Per Share (Cash EPS)
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  • Cash Flow Adequacy Ratio
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  • Cash Flow Coverage Ratio
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  • Cash Ratio
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  • Cash Reinvestment Ratio
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  • Cash to Current Assets Ratio
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  • Cash to Current Liabilities Ratio
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  • Cash to Working Capital Ratio
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  • Contribution Margin
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  • Current Ratio
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  • Current Yield
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  • Days Cash on Hand
    Days 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.
  • Days Sales in Inventory (DSI)
    Days sales in inventory (DSI) refers to a financial ratio showing the number of days a company takes to turn over all its inventory.
  • Days Sales Outstanding (DSO)
    Days Sales Outstanding (DSO) refers to the average number of days a company takes to collect its payments from the creditors.
  • Days Working Capital
    Days working capital is a measurement that reports the number of days it takes for the working capital to be converted into revenue.
  • Debits and Credits
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  • Debt Ratio
    Debt ratio is a measurement that indicates how much leverage a company uses to finance its operation by using debt instead of its truly owned capital or equity.
  • Debt Service Coverage Ratio
    The debt coverage ratio is used to determine whether or not a company can turn enough of a profit to cover all of its debt.
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  • Debt to Asset Ratio
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  • Debt to Capital Ratio
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  • Debt to EBITDA Ratio
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  • Debt to Equity
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  • Debt to Income Ratio (DTI)
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  • Debt to Net Worth Ratio
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  • Defensive Interval Ratio (DIR)
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  • Depreciation
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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.