Liquidity ratios examine whether a business has enough money to pay the money it owes. Liquidity ratios are important because they show you whether a business will be able to pay off its short term debt. They focus on short term debt (current liabilities) because liquidity is about daily income and expenses. A profitable business will not survive very long if it can not pay its daily expenses.
There are two liquidity ratios, click on the links below to learn more about them.
- Current ratio
- The acid test ratio
Liquidity ratios are written as ratios not percentages. This is because they tell us how many times a business can pay off its current liabilities using its liquidity money. Liquidity ratios are written against 1. For example if the liquidity ratio calculation gave me an answer of 2, I would write the ratio as 2:1. If the liquidity ratio is 2:1 the business has enough liquidity money to pay off current liabilities twice, if the ratio was 3:1 it means it can pay off current liabilities 3 times and so on.
Another way of explaining liquidity ratios is that a liquidity ratio of 2:1 means that current assets are twice the size of current liabilities. If the ratio is 3:1 it means current assets are 3 times the size of current liabilities, 4:1 means current assets are 4 times the size of current liabilities and so on.
The ideal liquidity ratio will depend on the business and the industry it is based in. Some businesses e.g. fresh food sellers will buy and sell stock daily, so they will need to pay their suppliers quickly and will therefore constantly need enough liquidity to cover current liabilities. Other businesses e.g. those buying services are likely to have arrangements (with suppliers) that gave them longer to pay e.g. 30, 60, 90 days so liquidity is not as important.
Liquidity & Working Capital
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