Liquidity ratio measures the ability of a company to meet its short term obligations. This ratio is important to short term creditors and bondholders.
Two common liquidity ratios are the current ratio and quick ratio.
Current Ratio
Current ratio is the number of times current assets cover currents liabilities. It is a measure of the company’s solvency or its ability to meet current liabilities as they fall due.
The example of current ratio:
The current ratio of 1.4 times means that the company’s current asset is able to cover its current liabilities by 1.4 times.
Current assets are assets which are convertible into cash within one year in a normal course of business. It includes cash, marketable securities, accounts receivable, prepaid expenses and inventories.
Current liabilities are the debts or liabilities of the company which must be paid within the normal operating cycle of the company, usually less than one year. Items found under a company’s current liabilities include accounts payable, current maturity of long term debt and accrued income taxes.
Quick Ratio
The current ratio may be refined by removing inventories, which is the least liquid current assets, from current assets before dividing by current liabilities. This ratio is known as the quick ratio or simple acid test ratio.
Example of quick ratio:
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