Liquidity in investing, liquidity is an entity’s ability to turn assets into cash or how quickly you can get your hands on money.
In business or accounting, the liquidity of the commercial bank is to pay short-term obligations and debts when they occur, and it is usually expressed as the current ratio, the liquidity ratio, or the debt ratio. A company’s liquidity is generally of particular concern to short-term borrowers, as its liquidity measures its ability to pay those creditors.
Generally, the higher the value of the liquidity ratio, the greater the margin of safety a company has in its ability to pay its bills.
4 liquidity ratio
Several capital ratios measure your company’s liquidity, with all the information coming from your balance sheet. These ratios are the current ratio, the speed ratio or acid test, and the gap or burn rate.
- The simplest is the current ratio. It is a ratio of total existing assets divided by total liabilities. It borrows from the investment explanation because it assumes that all the assets will be immediately converted into cash, which is often not the case. A value above 100% is not unusual when calculating the current ratio.
- The quick ratio, or acid test, measures business techniques to meet current liabilities from assets that can be sold quickly (although it is preferable to meet these obligations from cash flow). It subtracts inventory and prepayments from existing assets and divides them by current liabilities.
- The operating capital ratio is the company’s ability to satisfy current liabilities from current income rather than asset sales. It is a two-part calculation. Income statement cash flow is calculated by adding non-cash expenses (usually depreciation) and changes in working capital. The ratio is arrived at by dividing operating cash flow by current liabilities.
- The period, also known as the burn rate, looks at the number of days a business can operate using only cash. It is similar to the current and quick ratios as it is concerned with how easily a company can meet its current obligations. However, it is sometimes preferred to have short and current balances because it coordinates the actual number of days. In contrast, other ratios give a value that indicates the ability and ease to pay. The period is calculated by dividing quick assets, or these assets can be immediately converted into cash with daily operating expenses.
Also helpful is that net working capital, or working capital, is the total amount of all current assets minus all current liabilities, which measures a company’s short-term liquidity. It is also an indication of the ability of the company’s management to utilize assets efficiently.
A concern
While some business owners will consider all assets when calculating these liquidity ratios, some analysts will only use the most liquid assets, as they are looking at the worst-case scenario.