Liquidity ratios test the business firm if it has sufficient cash and assets that can be immediately converted to cash to pay off liabilities within a year. This is particularly helpful to financial institutions that had extended or are intending to extend credit to the business firm. At the same, the business firm will be guided through its financial planners on how they should manage their current assets taking into consideration the over-all financial picture of the firm.
In financial parlance, a ratio of 1.0 would indicate that the firm can pay all its current liabilities at a given period of time by cash and other short-term assets that could be readily sold and converted to cash. A more than 1.0 ratio would mean the firm has ample cash to settle its current obligations. A below 1.0 ratio, on the other hand, is indicative that the firm has negative working capital.
There are many possible scenarios that the firm might be in by analyzing liquidity ratios. The common types of liquidity ratios are: Current Ratio, Acid-test Ratio and Cash Ratio.
The Current Ratio (or Working Capital Ratio) test is to divide Current Assets by Current Liabilities. Basically, the current assets include cash, cash equivalents, short-term investments, marketable securities, accounts, receivable, inventory, prepaid expenses plus other assets that can be converted to cash in less than a year. Most financial analysts believe that a ratio between 1.2 to 2.0 is adequate. Meaning, the firm is in the comfort zone. If the firm has 1.0 or below, the management should start checking their inventories if these can be immediately converted to cash. If not, the firm will soon face serious liquidity issue. Having above 2.0 is not also good. It means the firm is not investing its excess assets, rather being left dormant.
The Acid-test Ratio (or Quick Ratio) is a stringent test that resolves whether the firm has sufficient short term assets to cover immediate obligations at short notice without selling inventory. Hence, this ratio only includes Cash, Cash Equivalents, Short-term Investments, Marketable Securities, Accounts Receivable, Prepaid Expenses divided by Current Liabilities. Example of a business that usually has below 1.0 ratio is a retail store that is highly dependent on inventory.
The third of the liquidity ratios is the Cash Ratio. This ratio further refines both the Current Ratio and the Acid-test Ratio. The Cash Ratio measures the degree to which a firm could quickly pay its short term liabilities. The creditors are more interested to know the Cash Ratio of the firm they had or are exposing credit to. To get this ratio the sum of Cash, Cash Equivalents + Short Term Investments is divided by the Current Liabilities. This is the most conservative ratio for it only considers the short term current assets minus the assets like the inventory that gives no assurance of being converted to cash at short notice.