A liquidity ratio refers to a company’s capacity to fulfill its short-term debts, which also has implications for a business’ ability to secure credit moving forward.
Companies calculate varying types of liquidity ratios by dividing total current assets by total current liabilities. Here, assets include liquid money as well as those holdings that can be quickly converted into cash. Typically, businesses with higher liquidity ratios (i.e. one or higher) are seen as safer and more likely to follow through on their obligations than those with lower ratios.
Importance of Tracking Liquidity
There are multiple reasons for companies to track liquidity ratios. Because lenders and financial analysts use liquidity ratios to assess a company’s creditworthiness, businesses that lack sufficient cash flow may struggle to secure loans. Additionally, liquidity ratios are of special interest to mortgage originators, who may deny you a loan if your liquidity is too low.
Of course, companies also have internal reasons for tracking their liquidity ratios. As your business’ financial manager, you are responsible for ensuring that the company can follow through on its commitments, such as accounts payable, salaries and tax bills in the coming quarters. By calculating liquidity on a regular basis, businesses can identify potential problems in the early stages, when it’s still possible to make adjustments.
Types of Liquidity Ratios
The following are the most commonly tracked liquidity ratios among business owners:
Current Ratio
The current ratio measures liquidity by comparing assets to liabilities. Also known as working capital ratio, a business’ current ratio is equal to total current assets divided by total current liabilities, or all the debts due within a year of statement data. Generally, current liabilities include accounts payable, wages payable and upcoming tax bills, as well as any principle payments on loans.
Many creditors feel that a current ratio of 2:1 indicates that a firm is financially healthy, while a smaller ratio can be suggestive of an unsound investment.
While most lenders believe a higher current ratio signifies a healthier company, experts warn that this tracking ratio is flawed. The current ratio measure relies on the assumption that a company can liquidate all its assets in order to satisfy liabilities. However, the fact is that many holdings are not easy to immediately convert to cash. To track fiscal health accurately, companies should utilize multiple liquidity ratios instead of relying on just one measure.
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