Liquidity

5.5.2 Liquidity

Liquidity refers to a company's ability to pay off its short-term liabilities (debts) using its short-term assets. A company needs sufficient liquid assets to meet its immediate financial obligations, such as salaries, rent, and supplier payments.

Key Liquidity Ratios

Two important liquidity ratios are the current ratio and the acid-test ratio. These ratios help assess a company's short-term solvency.

1. Current Ratio

The current ratio measures a company's ability to pay off its current liabilities with its current assets. It is a widely used indicator of short-term liquidity.

Formula

$$ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} $$

Interpretation

• Interpretation Rule: A current ratio of 2 or above is generally considered healthy.
• Current Ratio < 1: Indicates that the company may struggle to pay off its short-term liabilities.
• Current Ratio > 2: Suggests the company has a comfortable cushion to meet its short-term obligations.
• Current Ratio too high: Could indicate that the company is not efficiently using its current assets (e.g., holding too much cash or inventory).

Example Calculation

A company has current assets of $50,000 and current liabilities of $25,000. $$ \text{Current Ratio} = \frac{50,000}{25,000} = 2 $$ The current ratio is 2, which suggests the company has a good ability to pay off its current liabilities.

2. Acid-Test Ratio (Quick Ratio)

The acid-test ratio is a more stringent measure of liquidity than the current ratio. It excludes inventory from current assets because inventory may not be easily converted into cash.

Formula

$$ \text{Acid-Test Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} $$

Interpretation

• Interpretation Rule: An acid-test ratio of 1 or above is generally considered acceptable.
• Acid-Test Ratio < 1: Indicates that the company may have difficulty paying off its current liabilities without relying on the sale of inventory.
• Acid-Test Ratio > 1: Suggests the company has a strong ability to meet its short-term obligations without relying on inventory sales.

Example Calculation

A company has current assets of $50,000, inventory of $15,000, and current liabilities of $25,000. $$ \text{Acid-Test Ratio} = \frac{50,000 - 15,000}{25,000} = \frac{35,000}{25,000} = 1.4 $$ The acid-test ratio is 1.4, which suggests the company has a good ability to pay off its current liabilities without relying on selling its inventory.

Comparison Table

Ratio	Formula	Interpretation
Current Ratio	$$ \frac{\text{Current Assets}}{\text{Current Liabilities}} $$	Generally, a ratio of 2 or above is considered healthy.
Acid-Test Ratio	$$ \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} $$	Generally, a ratio of 1 or above is considered acceptable.

Understanding and interpreting liquidity ratios is crucial for assessing a company's financial health and its ability to meet its short-term obligations. These ratios provide valuable insights for investors, creditors, and management.