Liquidity ratios measure a company’s, i.e. its ability to convert its assets to cash and pay off its obligations (short term and long term obligations).
Types of Liquidity Ratios
Conmanly used Liquidity Ratios are
- Current Ratio
- Quick Ratio
- Cash Ratio
- Operating Cash Flow Ratio
It measures the capability of a company to meet its short-term obligations that are due within a year. It is defined as the ratio of its current assets to current liabilities. Current ratio is also known as the Working Capital Ratio.
Current Ratio = Current Assets / Current Liabilities
Assets and liabilities are classified into current and non-current on company balance sheet. Assets and liabilities are listed in the descending order of liquidity, i.e. assets appearing at the top are more liquid than assets at the bottom of the balance sheet.
It measure how well a company can satisfy its short term (current) financial obligations. It is also known as Acid Test Ratio. Quick ratio is calculated by dividing liquid current assets by current liabilities. Liquid current assets include cash, marketable securities and receivables.
Quick Ratio = (Cash and Cash equivalents + Marketable Securities + Receivables) / Current Liabilities
Liquid assets and liabilities are classified into current and non-current on company balance sheet. Cash and cash equivalents are the most liquid current assets. It include savings accounts, a term deposit with a maturity of fewer than 3 months. Marketable securities are liquid financial instruments that can be readily converted into cash. Receivables are the money owed to the company from providing customers with goods and/or services.
This ratio is a stricter and more conservative measure in comparison to Current ratio and Quick ratio. It is calculated by dividing cash and cash equivalents by current liabilities.
Cash Ratio = (Cash and Cash equivalents) / Current Liabilities
Operating Cash Flow Ratio
It measure company’s ability to pay off its current liabilities with the cash flow generated from its core business operations. It is defined as the ratio of its cash flow from operations to current liabilities.
Operating Cash Flow Ratio = Cash flow from Operations / Current Liabilities
Cash flow from operations can be found on a company’s statement of cash flows. Cash flow from operations include net income, non-cash expenses and changes in working capital.