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.
The diagram above depicts the two Liquidity ratios; Current ratio and Acid Test Ratio
The Current Ratio (which is sometimes also called Working Capital Ratio) examines how many times you will be able to pay current liabilities such as wages and tax using current liabilities. Read our article about Current Ratios to learn how to calculate Current Ratios.
The Acid Test Ratio just like the Current Ratio examines whether a business has enough money to pay it's liabilities. However for the Acid Test Ratio stock is not counted as an asset so it is excluded from the calculation. Read our article about Acid Test Ratios to learn how to calculate Acid Test Ratios.
How Are Liquidity Ratios Written
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.
What Does The Liquidity Ratio Number Mean?
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.
Ideal Liquidity Ratio
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.
