The current ratio is calculated by dividing current assets by current liabilities. A good range for the current ratio to fall within is typically 1.5 to 3. If the current ratio is 3, that means the company has enough current assets to pay for its current liabilities threefold. If the ratio is less than 1, the company does not have enough current assets on hand to pay for its current liabilities. If it is greater than 3, the company may not be using its assets to their maximum potential.
This ratio differs from the others in that it considers all current assets, not just the most liquid ones. It looks at a time frame of one year, which differs from the others as well.
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The quick ratio is calculated by dividing current assets without inventories by the current liabilities. Generally, a quick ratio of one or greater is good. If the quick ratio is greater than one, then the current assets without inventories can more than cover the current liabilities. If it is equal to 1, then the current assets without inventories are exactly enough to cover current liabilities. However, when it is less than 1, the company has insufficient current assets, without inventories, to cover their current liabilities.
This ratio looks at more liquid assets, so it excludes inventory in its calculation. Generally, the quick ratio is used with current assets that can be liquidated in 90 days or less.
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As previously mentioned, the cash ratio is calculated by dividing the cash and cash equivalents by the current liabilities. It essentially is a worst-case scenario measurement - if a company had to pay all its current liabilities immediately, the cash ratio shows the company's ability to do so with its current cash and cash equivalents.
If the cash ratio is less than 1, then the company has less cash and cash equivalents than they do in current liabilities and would not be able to pay off all current liabilities today. If it is greater than 1, they have more cash and cash equivalents than they do in current liabilities and would be more than able to pay off their current liabilities today. If it is equal to 1, then the company has exactly enough cash and cash equivalents to pay for its current liabilities.
This equation differs from the other liquidity ratios in that it only examines their cash and cash equivalents as opposed to all current assets. It is more conservative in this way than the other equations. The cash ratio is not often used as having that much cash on hand and is not really a great use of assets. It needs to be examined in conjunction with the industry and the company over time to really be able to gain insight from it.
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As mentioned before, the liquidity ratio can be calculated in three ways: the current ratio, the quick ratio, and the cash ratio.
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Current Assets - Inventories) / Current Liabilities
Cash Ratio = (Cash and Cash Equivalents) / Current Liabilities
Example
Use the balance sheet below to calculate the current, quick, and cash ratios.
| Current Assets | |
|---|---|
| Cash | $10,000 |
| Cash Equivalents | $25,000 |
| Accounts Receivable | $50,000 |
| Inventories | $100,000 |
| Current Liabilities | |
|---|---|
| Accounts Payable | $35,000 |
| Short-Term Debt | $10,000 |
| Notes Payable | $50,000 |
Current Ratio
As a reminder, the current ratio is equal to all current assets divided by all current liabilities. All current assets added together are equal to $185,000, and all current liabilities are equal to $95,000.
$185,000 / $95,000 = 1.947
The current ratio is equal to 1.947, which means that the current assets can pay the current liabilities 1.947 times. This is a good ratio to have since it has enough to pay its current liabilities but not too much. The interpretation will vary based on the company and industry, though.
Quick Ratio
The quick ratio is calculated by adding all current assets minus inventories and dividing by current liabilities.
$185,000 - $100,000 / $95,000 = 0.895
This results in a quick ratio of 0.895. This means that, with the assets that can be liquid in 90 days or less, the company can only pay off 89.5% of its current liabilities. This is not a terrible ratio, but it also is not great. Having a little more on-hand in liquid-able assets would be a good safety measure.
Cash Ratio
The cash ratio is equal to all cash and cash equivalents divided by the current liabilities.
$10,000 + $25,000 / $95,000 = 0.368
This company has a poor cash ratio of 0.368. This means that, when using its most liquid assets (cash and cash equivalents), the company would only be able to pay for 36.8% of its current liabilities. However, the cash ratio is not often looked at because having that much cash sitting around is not an efficient use of funds. Cases of current liabilities coming due immediately are few and far between, so it isn't necessary to keep that much cash on hand.
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The liquidity ratio is a computation used to measure the ability of the company to pay its short-term debt. It can be calculated by using the current ratio, the quick ratio (or acid-test ratio), and the cash ratio. The current ratio is equal to current assets divided by current liabilities. The quick ratio is equal to current assets less inventories divided by current liabilities. The cash ratio is equal to cash and cash equivalents divided by current liabilities.
The result from any of these equations can be interpreted the same way but should be analyzed based on the company and its industry. A liquidity ratio of less than 1 means that the company would not be able to fully cover its current liabilities with the assets used in the numerator of the equation. If it is equal to 1, the assets used in the equation are exactly enough to cover their current liabilities. If it is greater than 1, the assets used are more than enough to cover their current liabilities.
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Video Transcript
Liquidity Ratio Defined
In accounting, the term liquidity is defined as the ability of a company to meet its financial obligations as they come due. The liquidity ratio, then, is a computation that is used to measure a company's ability to pay its short-term debts. There are three common calculations that fall under the category of liquidity ratios. The current ratio is the most liberal of the three. It is followed by the acid ratio, and the cash ratio. These three ratios are often grouped together by financial analysts when attempting to accurately measure the liquidity of a company.
Current Ratio
The current ratio indicates a company's ability to pay its current liabilities from its current assets. This ratio is one used to quickly measure the liquidity of a company. The formula for the current ratio is:
Current Ratio = Current Assets ÷ Current Liabilities
Note that this formula considers all current assets and current liabilities. Current assets are those assets that are expected to turn into cash within one year. Examples of current assets are cash, accounts receivable, and prepaid expenses. Also included in this category are marketable securities such as government bonds and certificates of deposit. Current liabilities are those debts that are expected to be paid or come due within a year. Examples of current liabilities are accounts payable, payroll liabilities, and short-term notes payable.
Look at the following example:
Company A has the following information listed on its balance sheet:
Current Assets = $50,000
Current Liabilities = $25,000
What is the current ratio for Company A? Again, remember the formula:
Current Ratio = Current Assets ÷ Current Liabilities
So, if
the Current Ratio = $50,000 ÷ $25,000, then
the Current Ratio = 2 or 2 to 1
What does this mean? When interpreting the current ratio of Company A, you can see that for every $1 in current liabilities, the company has $2 in current assets. A current ratio that is better than 1 to 1 is considered good. The higher the ratio, the better the financial position of the company. Company A is in sound financial position, and the current ratio of 2 to 1 indicates that they can pay their short-term obligations.
Acid Ratio
The second ratio that we will discuss is the acid ratio. This ratio is also referred to as the quick ratio. The purpose of this ratio is to measure how well a company can meet its short-term obligations with its most liquid assets. Remember, liquid assets are those that can be quickly turned into cash. Most of the current assets are highly liquid with the exception of inventory, which often takes a longer amount of time to turn into cash. The formula for calculating the acid ratio is:
Acid Ratio = (Cash & Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities
Cash and cash equivalents refer to such things as cash on hand, checking accounts, savings accounts, and money market accounts. Short-term investments are any investments that will mature within 90 days, such as U.S. Treasury bills and commercial paper.
Let's look back at Company A. If the balance sheet for Company A gave us the following information, what would the acid ratio be?
Cash & Cash Equivalents = $20,000
Short-Term Investments = $5,000
Accounts Receivable = $10,000
Inventory = $15,000
Current Liabilities = $25,000
The formula, again, is:
Acid Ratio = (Cash & Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷ Current Liabilities
So then,
the Acid Ratio = ($20,000 + $5,000 + $10,000) ÷ $25,000 and so
the Acid Ratio = $35,000 ÷ $25,000 which means,
the Acid Ratio = 1.4 to 1
Interpreting the acid ratio for Company A shows us that for every $1 in liabilities, the company has $1.40 in liquid current assets. This ratio, like the current ratio, shows that Company A is in excellent financial position because it not only has enough assets to pay its short-term liabilities, but it also has money left over.
Cash Ratio
The final liquidity ratio that we will discuss is the cash ratio. Of the three ratio calculations, the cash ratio is the most stringent measurement of a company's liquidity. The cash ratio focuses strictly on the cash and cash equivalents of a company. Accounts receivables, inventory, and prepaid expenses are not as easy to convert to cash as cash equivalents are, thus are not considered for this calculation. The formula for the cash ratio is:
Cash Ratio = (Cash + Cash Equivalents) ÷ Current Liabilities
Look at the balance sheet information for Company A again. What is the cash ratio for this company?
If the Cash Ratio= $20,000 ÷ $25,000, then
the Cash Ratio = 0.80
Notice that the cash ratio is much smaller than the other two ratios. In analyzing the cash ratio, any ratio greater than 0.5 is considered good. In this case, the cash ratio is 0.8 to 1, meaning that for every $1 in current liabilities, there is $0.80 in current assets. Once again, analysts would say that Company A is financially sound.
Lesson Summary
Financial analysts, potential investors, and potential creditors all use liquidity ratios for the same purpose. They want to know if a company has enough liquid assets to meet its debt load. Companies that have higher liquidity ratios are able to meet their debt load, and are safer investments. Companies with lower liquidity ratios may very well be in danger of financial ruin. Liquidity ratios are also excellent tools for companies to use when performing company self-evaluations. Knowing the correct way to calculate each ratio and what each ratio means is a vital part of the financial world.
Key Terms
Liquidity - the ability of a company to meet its financial obligations as they come due
Liquidity ratio - a computation that is used to measure a company's ability to pay its short-term debts
Current ratio - measures a company's ability to pay its current liabilities from its current assets
Acid ratio - also known as quick ratio; measures how well a company can meet its short-term obligations with its most liquid assets
Liquid assets - assets which can be quickly turned into cash
Cash ratio - measures a company's ability to pay its current liabilities using only the cash and cash equivalents of the company
Learning Outcomes
After viewing this lesson, you should be able to:
- Name three types of liquidity ratios
- Calculate a company's liquidity using any one of the three ratios
- Judge the financial soundness of a company based on its liquidity ratios
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