Liquidity refers to a company's ability to meet current liabilities. The most common liquidity ratios include: net working capital, current ratio, acid-test ratio, and cash ratio.
The net working capital, or simply "working capital", is the difference between total current assets and total current liabilities. A positive amount means that the company is able to pay its current liabilities with its current assets. If it results in a negative amount, it means that current assets are not sufficient to cover for current liabilities. The net working capital also shows how much excess or deficiency there is.
Net working capital = Current assets - Current liabilities
The net working capital works as a "safety cushion" to creditors. Creditors want to know whether the company as enough current assets before extending new credit. A company has a better chance of acquiring credit if it maintains a good level of working capital.
The current ratio is equal to current assets divided by current liabilities. If current assets exceed current liabilities, the current ratio will result in a value that is greater than 1; otherwise, less than 1. Generally, a value greater than 1 is a favorable sign. It means that the company can meet its current liabilities with its current assets.
Current ratio = Current assets ÷ Current liabilities
The value of the current ratio shows how much current assets the company has for every current liability. For example, a current ratio of 1.5 means than the company has current assets is 1.5x more than current liabilities. For every dollar of current liability, the company has $1.5 of current assets to pay for it.
The acid test-ratio (or "quick ratio") measures the ability of a company to pay short-term liabilities using quick assets. Quick assets refer to the more liquid types of current assets, i.e. cash and cash equivalents, marketable securities, and short-term receivables. Inventories and prepayments are excluded from the computation.
Acid-test ratio = Quick assets ÷ Current liabilities
The cash ratio is an even more stringent measure of liquidity as it considers cash and marketable securities only. It shows whether the company has readily available cash and marketable securities to pay for its current liabilities.
Cash ratio = (Cash and equivalents + Marketable securities) ÷ Current liabilities
The above ratios measure the ability of a company to pay short-term obligations. They measure whether the company has enough current assets (or specific current assets) to meet current liabilities. These ratios provide an even useful insight when compared to benchmarks, such as past performance and industry averages.
Liquidity ratios measure the ability of a company to meet short-term liabilities using short-term assets.
