Liquidity ratios are the most basic of ratios lenders consider when evaluating a business’ ability to pay its short-term obligations. There are a three liquidity ratios business owners and managers should understand: 1) current ratio 2) quick ratio, and 3) cash ratio.
Current ratio calculation = current assets / current liabilities.
Since you pay for current liabilities with current assets it is essential to keep the ratio a positive number. Current assets and liabilities are always subtotaled on the balance sheet so they are easy to find on your company’s financials. Generally speaking, you want enough cash and other short term assets to be able to easily pay your company’s short-term liabilities. The higher the ratio, the more liquid your asset position is and the more able you are to keep up with your short-term obligations. Banks making long-term loans want to know that you have enough cash and other short-term assets to pay your monthly loan payments as well as other obligations, however lenders are even more concerned with your short-term liquidity ratios when making short-term loans or lines of credit. This is because there are almost always “call” provisions in short-term loans that make them due and payable upon demand.
Another liquidity ratio you should be familiar with is the quick ratio.
Quick ratio calculation = current assets – inventory / current liabilities
Although slightly more complicated to calculate, it heavily weighs cash, accounts receivable, and notes receivable that can easily be converted to cash. The quick ratio is a more accurate picture of a company’s ability to handle its short-term obligations then the current ratio because inventory is often difficult to convert to cash. The quick ratio is often called the acid test.
The last major liquidity ratio is the cash ratio.
Cash ratio = cash marketable securities / short-term liabilities
Because the cash ratio only considers cash and cash equivalents it is the most conservative of the liquidity ratios. As is true of the current and quick ratios, the higher the ratio, the more able a company is to meet its short-term obligations.
When bankers analyze a company’s financial statements they calculate these and many more ratios, then compare them to similar companies by NACIS code. First and foremost, they want to have an accurate picture of the financial health of the company, and secondly, they want to know how your company compares to your peers.
Sam Thacker is a partner in Austin Texas based Business Finance Solutions.
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