Liquidity Ratio: Definition, Calculation & Analysis

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  • 0:00 Liquidity Ratio Defined
  • 0:38 Current Ratio
  • 2:25 Acid Ratio
  • 4:27 Cash Ratio
  • 5:42 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

The financial stability of a company can be tested in many ways. One of the quickest ways to see just how well a company is performing is to use financial ratios. In this lesson, you will learn what liquidity ratios are, how to calculate them, and how to interpret them.

Liquidity Ratio Defined

In accounting, the term liquidity is defined as the ability of a company to meet its financial obligations as they come due. The liquidity ratio, then, is a computation that is used to measure a company's ability to pay its short-term debts. There are three common calculations that fall under the category of liquidity ratios. The current ratio is the most liberal of the three. It is followed by the acid ratio, and the cash ratio. These three ratios are often grouped together by financial analysts when attempting to accurately measure the liquidity of a company.

Current Ratio

The current ratio indicates a company's ability to pay its current liabilities from its current assets. This ratio is one used to quickly measure the liquidity of a company. The formula for the current ratio is:

Current Ratio = Current Assets ÷ Current Liabilities

Note that this formula considers all current assets and current liabilities. Current assets are those assets that are expected to turn into cash within one year. Examples of current assets are cash, accounts receivable, and prepaid expenses. Also included in this category are marketable securities such as government bonds and certificates of deposit. Current liabilities are those debts that are expected to be paid or come due within a year. Examples of current liabilities are accounts payable, payroll liabilities, and short-term notes payable.

Look at the following example:

Company A has the following information listed on its balance sheet:

Current Assets = $50,000
Current Liabilities = $25,000

What is the current ratio for Company A? Again, remember the formula:

Current Ratio = Current Assets ÷ Current Liabilities

So, if

the Current Ratio = $50,000 ÷ $25,000, then
the Current Ratio = 2 or 2 to 1

What does this mean? When interpreting the current ratio of Company A, you can see that for every $1 in current liabilities, the company has $2 in current assets. A current ratio that is better than 1 to 1 is considered good. The higher the ratio, the better the financial position of the company. Company A is in sound financial position, and the current ratio of 2 to 1 indicates that they can pay their short-term obligations.

Acid Ratio

The second ratio that we will discuss is the acid ratio. This ratio is also referred to as the quick ratio. The purpose of this ratio is to measure how well a company can meet its short-term obligations with its most liquid assets. Remember, liquid assets are those that can be quickly turned into cash. Most of the current assets are highly liquid with the exception of inventory, which often takes a longer amount of time to turn into cash. The formula for calculating the acid ratio is:

Acid Ratio = (Cash & Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities

Cash and cash equivalents refer to such things as cash on hand, checking accounts, savings accounts, and money market accounts. Short-term investments are any investments that will mature within 90 days, such as U.S. Treasury bills and commercial paper.

Let's look back at Company A. If the balance sheet for Company A gave us the following information, what would the acid ratio be?

Cash & Cash Equivalents = $20,000
Short-Term Investments = $5,000
Accounts Receivable = $10,000
Inventory = $15,000
Current Liabilities = $25,000

The formula, again, is:

Acid Ratio = (Cash & Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities

So then,

the Acid Ratio = ($20,000 + $5,000 + $10,000) ÷ $25,000 and so
the Acid Ratio = $35,000 ÷ $25,000 which means,
the Acid Ratio = 1.4 to 1

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