Learning Objectives

What are Liquidity Ratios?

Liquidity ratios measure the business ability to repay its short-term obligations. In other words, the word liquid refers to how quickly a business can convert assets to cash to repay its short term obligations.

The higher the liquidity ratio, the better, as it means there is more current assets over current liabilities. The lower the liquidity ratio, the worse, as it means there is more current liabilities over current assets.

Current Ratio (Working Capital Ratio)

The current ratio measures the amount of current assets over the current liabilities of the business. This is used to determine the ability of the business to repay its short-term obligations. Interpretations:

Greater than 1: The business has enough current assets to meet its short-term obligations. The higher the number the less risk in the business. (Higher the number, the better).

Less than 1: The business does not have enough current assets to meet its short-term obligations. The business may have to sell assets to meet the shortfall. (The lower the number, the worse it is).

Quick Asset Ratio

Quick asset ratio is a more refined version of the current asset ratio that excludes inventory and prepayments, as it measures the ability for a business to repay its short-term obligations without needing to sell inventory or prepayments (which can be difficult to sell). Inventory, if needed to be sold quickly, may be sold as a heavy discount that does not reflect its true value in the balance sheet. For current liabilities, we exclude the value of bank overdraft when calculating the quick asset ratio.

Interpretations:

Greater than 1: The business has enough quick assets to meet its short-term obligations. The higher the number the less risk in the business. (Higher the number, the better).

Less than 1: The business does not have enough quick assets to meet its short-term obligations. The business may have to sell assets to meet the shortfall. (The lower the number, the worse it is).