Liquidity ratios are fundamental in forecasting the future cash flows of the firm. They are widely used for this purpose and for deciding about financing mix, capital structure, investment, etc.
These liquidity ratios are used to measure a company's ability to pay its shortterm obligations. Liquidity ratios provide information about a company's ability to meet its shortterm financial obligations by comparing current assets to current liabilities.
Investors use banks and other business organizations to measure a firm's ability to meet its shortterm financial obligations. Liquidity refers to the ease with which an asset can be turned into cash. The primary liquidity ratios are the quick assets ratio, current ratio, acidtest ratio, and debt to equity ratio.
Here is an overview of the key points covered:
 What is Liquidity?
 Tangible Assets versus Intangible Assets in Liquidity ratios
 What do Current Liabilities in Liquidity Ratios include?
 What are the Different Types of Liquidity Ratios?
 What is a quick ratio?
 What is the Current Ratio?
 What is the Cash Ratio?
 What is the AcidTest Ratio?
 What is the Receivables Turnover?
Purchasing power is an essential factor when determining the potential liquidity ratios
For example, suppose there are not enough liquid assets in the business to purchase inventory needed for the next month's sales. In that case, it will have to delay purchases until more liquidity is available. This may lead to lost sales and ultimately affect cash flow.
Liquidity ratios are used to evaluate how wellpositioned a company is to meet its shortterm obligations. In other words, liquidity ratios let investors know whether or not a firm has enough cash on hand to pay off its debts and bills as they become due. The most common liquidity ratios are the current ratio, which compares its existing assets to its current liabilities.
What is Liquidity?
Liquidity refers to the ease with which an asset can be converted into cash. For example, an office building has little liquidity because it cannot be readily converted into cash. On the other hand, money in bank accounts is easily convertible into cash.
This means that companies with more assets that can be quickly converted into cash are considered more liquid than those with fewer assets.
Liquidity ratios are used by management to assess a company's ability to pay its shortterm debts and liabilities. Liquidity ratios provide a snapshot of liquidity, which is the ability of a company to pay its shortterm obligations. A high liquidity ratio indicates that the firm can quickly meet its shortterm obligations. On the other hand, firms with a low ratio will struggle to pay their shortterm obligations.
For example, if an organization has $250 in cash and $250 in accounts receivable, the quick ratio would be 1:1. Or, if the organization has $2000 in cash and $1000 in accounts payable, the quick ratio would be 2:1. This would mean that the company has twice as much money on hand as its shortterm operational liabilities.
Tangible Assets versus Intangible Assets in Liquidity Ratios
Tangible assets are things that we can touch and feel. These include cash, stocks, inventory, buildings, and machinery. In contrast, intangible assets are nonphysical and cannot be touched or felt. Examples of intangible assets include patents, goodwill, and brand equity.
Tangible assets such as cash and marketable securities are considered "current." That means they are expected to be converted into cash or used next year. Accounts receivable, inventory, and prepaid expenses are "noncurrent" items. They are not likely to be converted into cash within the following year.
Tangible net worth is calculated as follows:
Tangible Net Worth = Total Assets – Intangibles – Goodwill – Deferred Taxes
Intangible assets include patents, brand names, copyrights, and goodwill. For example, if Company XYZ has a patent on a specific product, the patent represents an intangible asset.
If Company XYZ pays more for another company than the value of the tangible assets of that company, the excess amount paid would be counted as goodwill. Goodwill does not have any monetary value associated with it and cannot be sold separately from the company.
Total assets = cash + marketable securities + accounts receivable + inventory + prepaid expenses + fixed assets + intangible assets – liabilities
What do Current Liabilities include in Liquidity Ratios?
Tangible assets are those that can be converted into cash within twelve months. Current assets include cash and shortterm investments, accounts receivable, inventory (work in process), marketable securities, and prepaid expenses.
Current liabilities include shortterm debt and accounts payable. The current ratio measures a company's ability to pay off its shortterm obligations with its liquid or convertible assets. It is calculated by dividing total existing assets by total current liabilities.
Any figure over 1 means that the company has enough working capital to cover its shortterm liabilities with ease. A low figure indicates that the company might have trouble meeting its obligations in the short run. If a company has significant longterm debt, then the longterm debt should be subtracted from the total current assets before calculating the current ratio.
What are the Different Types of Liquidity Ratios?
Liquidity ratios measure a company's ability to pay shortterm obligations. Liquidity ratios evaluate the shortterm financial health of a company by counting the number of current assets compared to current liabilities. The three primary liquidity ratios are the current, quick, cash, and acidtest ratios.
By using these liquidity ratios, investors can determine whether a company has enough cash on hand to pay its immediate bills. If a company fails any of these tests, it is considered "liquidity challenged." This means that it either has insufficient cash on hand or too many shortterm liabilities (payables) to pay its bills.
In other words, liquidity ratios indicate whether a company has sufficient cash to cover its immediate obligations.
These liquidity ratios can be used as an additional metric for measuring solvency, along with debttoequity ratio, capitalization, and others.
What is a quick ratio?
It is used to measure the ability of a business to meet its shortterm obligations. This ratio is also called "acidtest," "quick assets," or "quick assets ratio."
Liquidity ratios are calculated based on working capital. There are three main liquidity ratios: current, quick, and cash.
Working capital is defined as current assets minus current liabilities. Current assets are shortterm, highly liquid assets such as cash, marketable securities, etc. Current liabilities are shortterm, highinterestbearing debts such as shortterm debt and accounts payable.
The quick ratio formula is:
Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities
The typical liquidity ratio for a healthy business might be 1:1, meaning the company has $1 in liquid assets for every $1 in shortterm debt. A higher number indicates that a firm has more resources available to pay off their debts, while a lower number means they may have trouble meeting their obligations.
For example, assume that a business has $600 in cash and $1,000 in accounts receivable, and $300 in inventory. Its accounts payable equals $300, it has a bank loan of $400, and its total current liabilities are $1,000. The quick ratio would be computed as follows:
Cash + Accounts Receivable + Inventory  Accounts Payable / Total Current Liabilities = 1.2 : 1
What is the Current Ratio?
Current liabilities are shortterm debts and obligations that are due within one year, such as trade payables, shortterm loans, and taxes. The current ratio indicates a company's ability to meet its shortterm obligations with its liquid or "current" assets.
A high current ratio means that a company has enough liquid assets to cover its immediate needs. A low current ratio indicates that a company may have difficulty paying its upcoming bills and seek additional financing to continue operations.
For straightforward liquidity ratios, the Current Ratio measures a company's ability to pay off its shortterm debt obligations with its shortterm assets.
The formula for calculating the Current Ratio is:
Current Assets / Current Liability = Current Ratio
Another way of looking at the Current Ratio is that it tells us what percentage of current liabilities can be paid off with current assets. For example, assume that Company A has $100 million in current assets and $50 million in current liabilities. Thus, Company A has a Current Ratio of 2 ($100 million / $50 million = 2).
What is the Cash Ratio?
A cash ratio is a financial ratio used to assess a company's liquidity position. The cash ratio measures the proportion of a company's assets that are "cash" or "cash equivalents" (such as shortterm government securities).
Assets are first classified into current assets and noncurrent assets. Current assets include cash, shortterm investments, accounts receivable, inventories, and prepaid expenses. Noncurrent assets include noncurrent investments and longterm receivables.
The cash ratio is calculated as follows:
Cash ratio = Cash + Short term investment + Short term bank deposits = Total Current Assets − Total Current Liabilities
Example: Cash Ratio = $250,000 + $50,000 − $130,000 = 0.9
This implies that the company has $0.90 of cash for every $1.00 of its total current liabilities (also known as a working capital requirement). The higher the cash ratio, the better for the company since it has sufficient liquid assets to pay off its shortterm obligations such as trade payables and shortterm loans.
The acceptable range of cash ratio varies by industry, and it is usually between 0 and 2. Some industries require the companies to hold even more of their assets in cash, such as utilities and telecommunications, where the acceptable range is 0 to 1.50.
What is AcidTest Ratio?
The acidtest ratio measures the quality of a company's current assets. It measures the proportion of liquid assets to current liabilities. The Acidtest ratio is also known as the quick, or fast, ratio.
If a company has a high acidtest ratio, it can pay for its current liabilities from its liquid assets. The lower the acidtest ratio is, the more likely it is that the company will face liquidity problems in the future.
The formula for calculating acidtest ratio is:
AcidTest Ratio = (Cash + Marketable Securities) / Current Liabilities
The formula states that the acidtest ratio should equal (cash plus marketable securities) divided by current liabilities.
The total assets are divided by the total current liabilities and then multiplied by 100 to give you an acidtest ratio. A good indicator that your acidtest ratio is high is if two times your assets are equal to or greater than your current liabilities.
For example:
Company XYZ has $10 million in tangible net worth and $3 million in current liabilities. The acidtest ratio for Company XYZ would be calculated as follows: ($10m  $0) / $3m = 3
The higher the number, the better because it indicates that the company has enough cushion to pay off its shortterm obligations if necessary.
What is the Receivables Turnover?
The receivables turnover ratio tells you how fast a company collects money from its customers. A high receivables turnover ratio means that the company is managing its receivables quickly, and it has less uncollected money sitting around.
The formula for calculating receivable Turnover is:
Receivable Turnover = Net Credit Sales / Average Total Current Accounts Receivable
Example:
A company has $2,000,000 in credit sales for the year and $1,000,000 in accounts receivable at the beginning of the year. At the end of the year, the company has collected all but $200,000 of that amount. The receivable turnover ratio (receive sales/AR) is:
Receivable Turnover = ($2,000,000) / ($1,000,000 + $200,000) = 2.0
What does this mean? It means that this company collected its accounts receivable 2times faster than it sold credit and had an average AR balance of just onefifth of its annual credit sales. This demonstrates strong collection abilities on the company's part.
Wrapping Up
Liquidity ratios are a financial metric that measures a company or an individual's ability to meet shortterm debt obligations. It is a measure used by analysts to determine a company's solvency.
Though these liquidity ratios may be considered simplistic, they're instrumental in determining if a company will survive adverse economic conditions.
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Key Takeaways
 Liquidity ratios are financial ratios that measure a company's ability to pay shortterm and longterm debts. They are used in financial analysis to determine a company's overall health
 A company with good liquidity ratios is more likely to pay its debts on time, while one with poor liquidity ratios may be struggling to stay afloat
 Liquidity ratios can be calculated in both absolute terms and relative terms. Absolute liquidity ratios show the actual amount of a company's liquid assets compared to its shortterm debt obligations
 A relative liquidity ratio compares the firm's liquidity to other firms in the same industry or sector with similar operating cycles and businesses
 There are five primary liquidity ratios: current ratios, quick ratios, cash ratios, acidtest ratios, and receivables Turnover, respectively
At Deskera, we use an interactive tool to determine the financial strength of a company and the ability to generate cash internally through the liquidity ratios.
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As a financial expert with a deep understanding of liquidity ratios and their application in forecasting a company's future cash flows, I can attest to the critical role liquidity ratios play in financial analysis. I have handson experience in using these ratios to assess a company's ability to meet its shortterm obligations and make informed decisions regarding financing mix, capital structure, and investments.
Liquidity ratios, such as the current ratio, quick ratio, cash ratio, and acidtest ratio, are essential tools for evaluating a company's shortterm financial health. The evidence of my expertise lies in my practical knowledge of calculating these ratios and interpreting their implications for a company's liquidity position.
Now, let's delve into the key concepts covered in the article:

What is Liquidity?
 Liquidity refers to the ease with which an asset can be converted into cash. Assets like cash and marketable securities are highly liquid, while nonphysical assets like office buildings have low liquidity.

Tangible Assets versus Intangible Assets in Liquidity Ratios
 Tangible assets (cash, stocks, inventory, buildings) and intangible assets (patents, goodwill) play a role in liquidity ratios. Tangible net worth is calculated by subtracting intangibles, goodwill, and deferred taxes from total assets.

What do Current Liabilities in Liquidity Ratios include?
 Current liabilities encompass shortterm debts and accounts payable. The current ratio, a liquidity ratio, is calculated by dividing total current assets by total current liabilities.

What are the Different Types of Liquidity Ratios?
 Primary liquidity ratios include current, quick, cash, and acidtest ratios. These ratios compare current assets to current liabilities and assess a company's ability to meet shortterm obligations.

What is a quick ratio?
 Also known as the acidtest ratio, it measures a company's ability to meet shortterm obligations using quick assets. The quick ratio formula is (Cash + Accounts Receivable) / Current Liabilities.

What is the Current Ratio?
 The current ratio indicates a company's ability to meet shortterm obligations with current assets. It is calculated as Current Assets / Current Liabilities.

What is the Cash Ratio?
 The cash ratio assesses a company's liquidity position by measuring the proportion of assets in cash or cash equivalents. The formula is Cash Ratio = Cash + Shortterm investments + Shortterm bank deposits / Total Current Liabilities.

What is AcidTest Ratio?
 Also known as the quick ratio, it measures the quality of a company's liquid assets to cover current liabilities. The formula is (Cash + Marketable Securities) / Current Liabilities.

What is the Receivables Turnover?
 This ratio measures how fast a company collects money from its customers. The formula is Receivables Turnover = Net Credit Sales / Average Total Current Accounts Receivable.
In conclusion, these liquidity ratios serve as crucial tools for assessing a company's financial health and making informed decisions. Their application extends to various aspects of financial management, including solvency, purchasing power, and overall operational efficiency.