|Course 304: Interpreting the Numbers|
In a nutshell, a company's liquidity is its ability to meet its near-term obligations, and it is a major measure of financial health. Liquidity can be measured through several ratios.
Current ratio. The current ratio is the most basic liquidity test. It signifies a company's ability to meet its short-term liabilities with its short-term assets. 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.
Current Ratio = (Current Assets) / Current Liabilities
Quick Ratio. The quick 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.
Quick Ratio = (Cash + Accounts Receivable + Short-Term or Marketable Securities) / (Current Liabilities)
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. Along with the quick ratio, a higher cash ratio generally means the company is in better financial shape.
Cash Ratio = (Cash + Short-Term or Marketable Securities) / (Current Liabilities)
Next: Leverage Ratios >>
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