Question

Since liquidity ratios are so important to evaluating business performance, what are some examples?

Answer 1

Liquidity Ratios are used to measure a company's short term ability to pay its maturing obligations and to meet unexpected need for cash. Liquid assets or the current assets can be converted into cash within a short time and this cash helps a company to discharge its obligations when they arise. The stronger is the liquidity ratio, the more stable the company will be as it would face no problem in meeting its obligations as when they arise.

Examples of Liquidity Ratios are

1. Current Ratio

Current Ratio = Current Assets / Current Liabilities

This ratio measures company's ability to pay its short term obligations that would arise in the span of a year.

2. Quick Ratio

= (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities

This ratio measures the ability of the company to pay its short term obligations with the help of Quick assets or the assets which can be easily converted into cash. It is to be noted that inventory is not a quick asset as it takes time to be made and to be sold.

3. Cash ratio

= Cash & Cash equivalents / Current Liabilities

This ratio measures the ability to pay short term obiligations using cash and cash equivalents. Cash equivalenst are those assets which can be easily converted into cash.