What is Liquidity Ratio? (Definition, Formula, Example)

July 13, 2022

What is Liquidity Ratio? (Definition, Formula, Example)

Liquidity ratio is one of the most important ratios for a company to understand and monitor. It tells you how easily your company can pay its debts as they come due.

The liquidity ratio is calculated by dividing current assets by current liabilities. This number tells you how long your company could continue to operate if it had to liquidate all its assets immediately.

In this article, we will explain the liquidity ratio, how to calculate the liquidity ratio, and what is a good liquidity ratio. We will also provide you with a liquidity ratio formula so that you can calculate the liquidity ratio for your own company.

What are the 5 liquidity ratios?

The 5 liquidity ratios are:

  • Current ratio - This liquidity ratio measures a company's ability to pay its short-term obligations with its short-term assets.
  • Quick ratio - This liquidity ratio is similar to the current ratio, but it only includes those assets that can be quickly converted into cash.
  • Working capital - This liquidity ratio measures a company's ability to pay its short-term obligations with its available cash.
  • Cash ratio - This liquidity ratio measures a company's ability to pay its short-term obligations with its available cash and cash equivalents.
  • Days sales outstanding - This liquidity ratio measures the number of days that it takes a company to collect payment from its customers.

Each liquidity ratio measures a different aspect of a company's liquidity. The most common liquidity ratios are the current ratio and the quick ratio. These two ratios are often used to measure a company's short-term liquidity.

The current ratio is the most common liquidity ratio. It measures a company's ability to pay its short-term obligations with its available cash and cash equivalents. The current ratio is calculated by dividing a company's total assets by its total liabilities.

The quick ratio is another liquidity ratio that measures a company's ability to pay its short-term obligations with its available liquidity. The quick ratio is calculated by dividing a company's total assets by its total liabilities, excluding inventory.

There are other liquidity ratios that focus on different aspects of liquidity. For example, the acid-test ratio measures a company's ability to pay its short-term obligations with its liquidity, excluding inventory and other assets that may be difficult to liquidate.

The cash ratio is the most conservative liquidity ratio because it only focuses on cash and cash equivalents. The cash ratio is calculated by dividing a company's total cash by its total liabilities.

What is a good liquidity ratio?

A liquidity ratio of two or higher is generally considered to be good. This means that the company has twice as many liquid assets as it does liabilities.

A liquidity ratio of one or lower is generally considered to be poor. This means that the company has more liabilities than it does liquid assets.

The ideal liquidity ratio depends on the industry that the company is in.

For example, banks are required to maintain a liquidity ratio of at least 0. The reason for this is because banks need to have enough cash on hand to cover all of their withdrawals.

Manufacturing companies, on the other hand, usually have a liquidity ratio of around two. This is because they need to have enough money to cover the cost of raw materials and inventory.

How to calculate the liquidity ratio

The formula for liquidity ratio is:

Liquidity Ratio = (Current Assets - Inventory) / Current Liabilities

As you can see, the liquidity ratio is a simple way to measure a company's ability to pay its short-term debts.

A company with a liquidity ratio of two can pay its short-term debts twice over, while a company with a liquidity ratio of 0.50 can only pay half of its short-term debts.

What is an example of a liquidity ratio?

A good example of a liquidity ratio is the acid-test ratio, which is also known as the quick ratio.

The acid-test ratio is a liquidity ratio that measures a company's ability to pay its short-term debts with its most liquid assets.

The formula for the acid-test ratio is:

Acid-Test Ratio = (Current Assets - Inventory) / Current Liabilities

As you can see, the acid-test ratio is very similar to the liquidity ratio.

The main difference between the two ratios is that the acid-test ratio excludes inventory from its calculation of current assets.

This is because inventory can take longer to sell than other assets, such as cash and accounts receivable.

How to use LiveFlow to track your liquidity ratio

With LiveFlow you can automatically import your Balance Sheet from QuickBooks into Google Sheets without any manual work required, enabling you to focus on your business rather than data entry.

You can also use our liquidity ratio template, which will automatically calculate this ratio for you based on the Balance Sheet data imported from QuickBooks.

To learn more about how LiveFlow can help you automate your financial modeling, schedule a demo with one of our experts today.

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