What are the types of liquidity ratios? explain with formula and example?

 

There are three main types of liquidity ratios that are commonly used to evaluate a company's short-term financial health:

Current Ratio: 

This ratio measures a company's ability to pay off its short-term obligations using its current assets. It is calculated by dividing current assets by current liabilities. A ratio of 1 or higher is considered healthy, indicating that a company has enough liquid assets to pay off its short-term debts.

Example: A company has current assets of $1,000,000 and current liabilities of $800,000. The current ratio would be calculated as: Current Ratio = Current Assets / Current Liabilities Current Ratio = 1,000,000 / 800,000 Current Ratio = 1.25 This ratio of 1.25 indicates that the company has 1.25 times the amount of current assets as current liabilities, which is considered healthy.

Quick Ratio: 

Similar to the current ratio, the quick ratio measures a company's ability to pay off its short-term obligations, but it excludes inventory from current assets because it is considered the least liquid of all current assets. It is calculated by dividing (current assets minus inventory) by current liabilities. A ratio of 1 or higher is considered healthy.

Example: A company has current assets of $1,000,000, inventory of $200,000 and current liabilities of $800,000. The quick ratio would be calculated as: Quick Ratio = (Current Assets - Inventory) / Current Liabilities Quick Ratio = (1,000,000 - 200,000) / 800,000 Quick Ratio = 0.75 This ratio of 0.75 indicates that the company has 0.75 times the amount of current assets minus inventory as current liabilities, which is considered less healthy than a ratio of 1 or higher.

Cash Ratio: 

This ratio measures a company's ability to pay off its short-term obligations using only its cash and cash equivalents. It is calculated by dividing cash and cash equivalents by current liabilities. A ratio of 1 or higher is considered healthy.

Example: A company has cash and cash equivalents of $500,000 and current liabilities of $800,000. The cash ratio would be calculated as: Cash Ratio = Cash and Cash Equivalents / Current Liabilities Cash Ratio = 500,000 / 800,000 Cash Ratio = 0.625 This ratio of 0.625 indicates that the company has 0.625 times the amount of cash and cash equivalents as current liabilities, which is considered less healthy than a ratio of 1 or higher.