How are Liquidity Ratios calculated?

Liquidity refers to a company’s ability to meet its current obligations. These ratios, then, are related to a company’s assets and liabilities classified as current (by definition, likely to mature within one year). The most common of these is the Current Ratio:

Current Ratio = (Current Assets / Current Liabilities)

When interpreting this ratio, the analyst must consider the component items of current assets and current liabilities. For example, a company with most of its current assets in accounts receivable is more liquid than a company with most of its current assets in inventory. The Acid Test ratio can highlight these characteristics:

Acid Test Ratio = (Quick Assets / Current Liabilities)

Quick Assets include cash, short-term marketable securities, and accounts receivable. The assumption is that these items can be converted into cash quickly and at amounts close to those stated on the balance sheet.

Again, the nature of the underlying figures must be examined carefully. The accounts receivable number for a utility is usually reliable. Those accounts (excepting budget accounts) are due within thirty days. Most of the bills are paid within the time specified because customers do not want to risk an interruption in their power supply. The accounts receivable of an electronic equipment company, however, may be collectible only after the equipment has been tested and may be subject to deductions for rework and other claims.

No universal rule of thumb defines a “good” or “bad” current or acid-test ratio. A high current ratio, such as 3:1, may look good to a creditor. From the business owner’s viewpoint, however, maintaining such a high ratio requires large amounts of idle cash. The owner may prefer to use the cash to repay long-term debt, which would lower the company’s liquidity ratios, but might reduce its risk exposure. Thus, interpreting these ratios calls for caution and a knowledge of industry characteristics, the seasonal nature of the business, and the quality of assets and liabilities.