Understanding what information liquidity ratios provide is important to the business owner and investor. This article shows how to calculate three commonly used indicators of liquidity and how to interpret the results.

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### Why Measure Liquidity?

If a business can't meet day-to-day financial obligations, then it won't be around very long. Other than coming up short when it's time to pay the bills, how does a company assess its ability to meet current obligations? Liquidity ratio analysis, using information from the Balance Sheet, is a widely-used technique to measure this capability. For example, banks often require borrowers to maintain minimum liquidity thresholds as a condition of a loan. Investors will have certain expectations depending upon the type of business. When evaluating opportunities, owner's need to feel confident that there is sufficient excess cash to meet unexpected needs.

The following sections outline what information liquidity ratios provide and how to crunch the numbers.

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### Current Ratio

The most basic ratio used to measure liquidity is the current ratio.

**The calculation**:*Current Assets / Current Liabilities = Current Ratio***Example:**$300,000 / $100,000 = 3**Where to get the numbers**:*Current Assets*are a subtotal on the Balance Sheet. Cash and other assets that can be reasonably converted to cash during a normal operating cycle (usually about one year) are classified as a current asset. Accounts include cash, short-term investments, accounts receivables, prepaid expenses and inventory.*Current Liabilities*are another subtotal on the Balance Sheet. Obligations that must be satisfied during a normal operating cycle (usually about one year) are classified as a current liability. Accounts include trade accounts, short-term notes payable, payroll liabilities and sales and excise taxes payable.**What it means**:The current ratio shows the amount of assets available to pay current obligations. In our example, $3 in current assets are available to repay every $1 in current liabilities. Interested parties, such as lenders or suppliers, like to see a current ratio larger than 1. A ratio of 1.5 is usually considered strong.

A business must hold a certain amount of cash to meet obligations. However, cash does not earn a large return. Instead of holding a non-productive asset, the cash could be put toward other uses that would make more money. The current ratio assesses how the business is balancing their use of cash.

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### Quick Ratio

The quick ratio tightens the analysis of liquidity by excluding certain assets:

**The calculation**:*Cash + Short-Term Investments + Receivables / Current Liabilities = Quick Ratio***Example:**25,000 + 10,000 + 75,000 / 100,000 = 1.1**Where to get the numbers**:Subtract inventory and prepaid expenses from the

*Current Assets*subtotal on the Balance Sheet to arrive at the numerator. Only the most liquid assets are used in this calculation. Use the same*Current Liability*subtotal used in the calculation of the Current Ratio.**What it means**:The Quick Ratio, also known as the Acid-Test Ratio, measures if a business could pay current obligations if they became due immediately. Because it can be difficult to liquidate inventory, the Quick Ratio excludes this asset from the calculation. Prepaid expenses are excluded for the same reason. Because of these exclusions, the Quick Ratio will also be less than the Current Ratio. The Quick Ratio is most applicable to businesses that carry inventory. The desirable ratio varies by industry.

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### Working Capital

Another way to look at a business's ability to meet current obligations is to calculate how much working capital is available.

**The calculation**:*Current Assets - Current Liabilities = Working Capital***Example:**$300,000 - $100,000 = $200,000**Where to get the numbers**:Use the same

*Current Assets*and*Current liabilities*subtotals on the Balance Sheet used to calculate the Current Ratio.**What it means**:Working capital identifies the amount of current assets that can be used after current liabilities are paid. The optimum amount varies by industry and takes into consideration such things as how quickly inventory turns over.

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### Conclusion

New perspectives and insights become available when financial statement information is presented and analyzed in a different form. Understanding what information liquidity ratios provides may prompt the savvy business person to:

- Predict financial problems
- Explore opportunities to invest current assets more wisely
- Compare ratios with competitors and identify areas for improvement
- Ensure that sufficient liquid assets will exist when exploring new opportunities.

Image Credit: http://www.sxc.hu/photo/1120745

References:

Needles, Jr. Belverd E., and Marian Powers. Financial Accounting. 9 ed. Boston: Houghton Mifflin Company, 2007. Print.