Liquidity ratios

Definition

Liquidity ratios are financial metrics that measure a company’s ability to meet its short-term financial obligations with its readily available assets.

What are liquidity ratios?

These ratios provide insight into a company’s liquidity, which is its ability to convert assets into cash quickly without significant loss in value. Liquidity ratios are crucial for assessing a company’s short-term financial health, as they indicate whether the company has enough liquid resources to cover its immediate liabilities.

Factors affecting liquidity ratios:

1. Industry differences: Different industries have varying levels of acceptable liquidity due to differences in business models, capital requirements, and inventory turnover.
2. Business life cycle: Companies at different stages of their life cycle may have different optimal levels of liquidity.
3. Economic conditions: Economic conditions, including interest rates and access to credit, can affect a company’s liquidity position.

Creditors, such as banks and suppliers, use liquidity ratios to assess a company’s ability to repay its debts. Investors may also analyse these ratios to evaluate a company’s short-term financial health and stability.

Liquidity ratios do not provide information about a company’s long-term financial health or its ability to generate profits. Therefore, they should be used in conjunction with other financial metrics.

Example of a liquidity ratio

Let’s consider Company ABC, which has the following financial information:

• Current assets: £300,000
• Current liabilities: £200,000

Using this information, we can calculate the current ratio:

Current ratio = Current assets / Current liabilities​

Current Ratio = £300,000 / £200,000 = 1.5​

In this example, Company ABC has a current ratio of 1.5. This means that for every dollar of current liabilities, the company has £1.50 of current assets available to cover those obligations.