LIQUIDITY RATIOS

Liquidity ratios attempt to measure a company's ability to pay off its short-term debt obligations. They come off the Balance Sheet and hence measure the liquidity of the company as on a particular day i.e. the day that the Balance Sheet was prepared. The greater the coverage of liquid assets to short-term liabilities the better as it is a clear signal that a company can pay its debts that are coming due in the near future and still fund its ongoing operations.

Common liquidity ratios include the current ratio, the quick ratio and the cash flow ratio. A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern.

Current Ratio

The current ratio is a popular financial ratio used to test a company's liquidity. It signifies a company's ability to meet its short-term liabilities with its short-term assets. While short term creditors prefer a high current ratio since it reduces their risk, shareholders may prefer a lower current ratio so that more of the firm's assets are working to grow the business. A current ratio greater than or equal to one indicates that current assets should be able to satisfy near-term obligations. A current ratio of less than one may mean the firm has liquidity issues. A general rule of thumb for the current ratio is 2:1. However, an industry average may be a better standard than this rule of thumb. The actual quality and management of assets must also be considered.

Current Ratio = (Current Assets) / Current Liabilities

Example: As of December 31, 2009, XYZ Ltd had following current assets

Cash	$ 5,000
Accounts Receivable	10,000
Inventory	15,000
	-----------
	$ 30,000
Current Liabilities	$ 12,000
Using the formula for Current Ratio, for XYZ it can be calculated as follows
	30000
Current Ratio =	--------- = 2.5
	12000

The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better.

Quick Ratio

The quick ratio also known as the Acid-test ratio, is a tougher test of liquidity than the current ratio. It eliminates certain current assets such as inventory and prepaid expenses that may be more difficult to convert to cash. Like the current ratio, having a quick ratio above one means a company should have little problem with liquidity. The higher the ratio, the more liquid it is, and the better able the company will be to ride out any downturn in its business. A general rule of thumb states that the ratio should be 1:1 .

Quick Ratio = (Cash + Accounts Receivable + Short-Term or Marketable Securities) / (Current Liabilities)

Taking the above example of XYZ Ltd, Quick ratio for the same can be calculated as follows:

	(5000 + 10000)
Quick Ratio =	---------------- = 1.25
	12000

In addition to providing an idea about the liquidity of the company, when compared with the current ratio, a significantly lower quick ratio, is a clear indication that the company's current assets are dependent on inventory.

Cash Ratio

The cash ratio is the most conservative liquidity ratio of all. It only measures the ability of a firm's cash, along with investments that are easily converted into cash, to pay its short-term obligations. The cash ratio is seldom used in financial reporting or by analysts in the fundamental analysis of a company as it is not realistic for a company to purposefully maintain high levels of cash assets to cover current liabilities. The reason being that it's often seen as poor asset utilization for a company to hold large amounts of cash on its balance sheet, as this money could be returned to shareholders or used elsewhere to generate higher returns.