Types of Liquidity Ratios
A liquidity ratio is a type of financial ratio used to determine a company’s ability to pay its short-term debt obligations. The metric helps determine if a company can use its current, or liquid, assets to cover its current liabilities.
1. Current Ratio:
Current Ratio = Current Assets / Current Liabilities
The current ratio is the simplest liquidity ratio to calculate and interpret. Anyone can easily find the current assets and current liabilities line items on a company’s balance sheet. Divide current assets by current liabilities, and you will arrive at the current ratio.
2. Quick Ratio or Acid test ratio:
Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities
The quick ratio is a stricter test of liquidity than the current ratio. Both are similar in the sense that current assets are the numerator, and current liabilities are the denominator.
However, the quick ratio only considers certain current assets. It considers more liquid assets such as cash, accounts receivables, and marketable securities. It leaves out current assets such as inventory and prepaid expenses because the two are less liquid. So, the quick ratio is more of a true test of a company’s ability to cover its short-term obligations.
3. Times interest earned ratio:
Times interest earned ratio= Income before interest and taxes or EBIT / Interest expense
The times interest earned ratio, sometimes called the interest coverage ratio, is a coverage ratio that measures the proportionate amount of income that can be used to cover interest expenses in the future.
In some respects, the times interest ratio is considered a solvency ratio because it measures a firm’s ability to make interest and debt service payments. Since these interest payments are usually made on a long-term basis, they are often treated as an ongoing, fixed expense. As with most fixed expenses, if the company can’t make the payments, it could go bankrupt and cease to exist. Thus, this ratio could be considered a solvency ratio.
4. Cash Ratio or Absolute Liquidity Ratio:
The cash ratio is a measure of a company’s liquidity in which it is measured whether the company has the ability to clear off debts only using the liquid assets (cash and cash equivalents such as marketable securities). It is used by creditors for determining the relative ease with which a company can clear short-term liabilities.
It is calculated by dividing the cash and cash equivalents by current liabilities.
Cash ratio = Cash and equivalent / Current liabilities
5. Working capital ratio:
The working capital ratio, also called the current ratio, is a liquidity ratio that measures a firm’s ability to pay off its current liabilities with current assets. The working capital ratio is important to creditors because it shows the liquidity of the company.
Current liabilities are best paid with current assets like cash, cash equivalents, and marketable securities because these assets can be converted into cash much quicker than fixed assets. The faster the assets can be converted into cash, the more likely the company will have the cash in time to pay its debts.
The reason this ratio is called the working capital ratio comes from the working capital calculation. When current assets exceed current liabilities, the firm has enough capital to run its day-to-day operations. In other words, it has enough capital to work. The working capital ratio transforms the working capital calculation into a comparison between current assets and current liabilities.
It is calculated as:
Working capital ratio= current assets/current liabilities
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