Liquidity Ratio Definition & Meaning

There are many methods of examining the ability of a debtor to pay off its liabilities, examples of liquidity ratios include quick ratio or acid-test ratio, cash ratio, current ratio, capital ratio and others. Liquidity ratios also examine the sufficiency of the current assets of a debtor to clear its liabilities without accessing any external funding. Fundamentally, all liquidity ratios computed by dividing current assets by current liabilities assess a company’s capacity to pay short-term commitments . The quick ratio also includes marketable securities, accounts receivable, and cash equivalents, whereas the cash ratio just considers the amount of cash on hand divided by CL.

The quick ratio suggests an even more dire liquidity position, with only $0.20 of liquid assets for every $1 of current liabilities. A liquidity ratio is used to determine a company’s ability to pay Liquidity Ratio Definition & Meaning its short-term debt obligations. With just SAR 0.80 of current assets available to pay every SAR 2 of current obligations, the company’s current ratio of 0.4 shows a lack of appropriate liquidity.

Liquidity Coverage Ratio (LCR) Definition & Calculation

Generally, the firm having a liquidity ratio greater than 1 is considered to be financially sound and is able to meet its short-term obligations with ease. The liquidity ratios are concerned with the current assets and the current liabilities. Current assets are liquid assets that can be converted to cash within one year such as cash, cash equivalent, accounts receivable, short-term deposits and marketable securities. The current liabilities refer to the business’ financial obligations that are payable within a year. The current ratio, also known as the working capital ratio, measures the business’ ability to pay off its short-term debt obligations with its current assets. The cash ratio compares just cash and readily convertible investments to current liabilities.

Liquidity Ratio Definition & Meaning

Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes. Let’s utilize a few of these liquidity measurements to illustrate how well they may be used to evaluate the financial health of a firm. As mentioned before, the quick ratio is usually referred to as the acid-test ratio.

Definition of Liquidity Ratio

This information is useful to compare the company’s strategic positioning 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. Creditors analyze liquidity ratios when deciding whether or not they should extend credit to a company. They want to be sure that the company they lend to has the ability to pay them back. Any hint of financial instability may disqualify a company from obtaining loans.

Liquidity Ratio Definition & Meaning

For example, supplier agreements can make a difference to the number of liabilities and assets. A large retailer like Walmart may negotiate favorable terms with suppliers that allow it to keep inventory for longer periods and have generous payment terms or liabilities. Current liabilities refers to the sum of all liabilities that are due in the next year. These ratios assess the overall health of a business based on its near-term ability to keep up with debt. Acid Test – a ratio used to determine the liquidity of a business entity. If one assumes the traditional observance of the liquidity ratio by the bankers, this would obviously limit the lending potential of the banks.