4.4 : Liquidity Ratios

Liquidity ratios are essential for assessing a company's ability to meet its short-term debt obligations. These ratios offer a clear snapshot of its financial health by measuring a business's capacity to convert assets into cash to pay off liabilities due within a year. The commonly used liquidity ratios, the current, quick, and liquid ratios, are invaluable in this regard.

The current ratio is calculated by dividing current assets by current liabilities. This ratio helps evaluate whether a business has enough resources to cover its short-term liabilities with its assets.

The quick ratio, or the acid-test ratio, provides a more stringent assessment by excluding less liquid current assets like inventory from the numerator. This ratio helps stakeholders understand a company's ability to meet short-term obligations without relying on the sale of inventory.

The liquid ratio, or the cash ratio, is a liquidity metric that measures a company's ability to cover its short-term liabilities using only its most liquid assets: cash and cash equivalents. This ratio indicates how well a company can immediately settle its debts without relying on the sale of inventory or receivables.

These ratios are valuable during economic downturns when maintaining liquidity is crucial for survival.