Liquidity ratios measure a business’s ability to pay off it’s short-term debts if it was forced to utilize all of its short-term assets immediately. In this category of ratios, the cash resources, accounts receivable and inventory assets are compared to the amount of your accounts payable and other short-term liabilities to determine if your business can make these payments at a moment’s notice.
Low liquidity ratios can indicate that your business might have difficulty in paying its debts and will not be in a position to take advantage of new expansion opportunities that require immediate cash. On the other hand, a higher liquidity ratio may indicate that you have too much capital that is being underused and it could be better invested in developing a new product or boosting your marketing.
The two most commonly used liquidity ratios are the current ratio and the acid-test ratio.
Current Ratio = Current Assets / Current Liabilities
The current ratio considers whether all of your assets [cash, accounts receivable and inventory] are adequate to cover all of your current liabilities upon immediate notice.
Acid Test Ratio [or “Quick Ratio”] = [Cash + Accounts Receivable] / Current Liabilities
The acid-test ratio considers whether all of your assets [cash, accounts receivable and inventory] are adequate to cover all of your current liabilities upon immediate notice.
