Liquidity Ratio

Liquidity ratios are financial metrics used to evaluate a company’s ability to meet short-term financial obligations with its liquid assets. These ratios assess the company’s capability to cover immediate liabilities using its available short-term assets.

Current Ratio: This ratio compares a company’s current assets to its current liabilities. It’s calculated by dividing total current assets by total current liabilities.

Quick Ratio (Acid-Test Ratio): It measures a company’s ability to meet short-term obligations with its most liquid assets, excluding inventory. The formula is (Current Assets – Inventory) / Current Liabilities.

Assessment of Short-Term Solvency: Liquidity ratios provide insights into a company’s ability to honor short-term financial commitments.

Risk Evaluation: These ratios assist in evaluating the risk associated with the company’s liquidity position and its ability to manage immediate financial needs.

Financial Health Indicator: Strong liquidity ratios demonstrate a company’s ability to manage its short-term obligations efficiently.

Investor and Creditor Confidence: Higher liquidity ratios often boost confidence among investors and creditors, indicating the company’s ability to handle short-term liabilities.

For instance, if a company has a current ratio of 2, it means it has ₹2 in current assets for every $₹1 in current liabilities. This ratio implies a more favorable capacity to meet immediate financial obligations.

Liquidity ratios serve as crucial indicators of a company’s short-term financial health, offering valuable insights into its capacity to manage immediate financial obligations. These ratios play a vital role in providing a snapshot of a company’s liquidity position and influencing stakeholders’ confidence in its financial stability.