Why Is Liquidity Ratio Important?

Why Is Liquidity Ratio Important?
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There are three primary liquidity ratios that credit analysts and investors use to begin an in-depth financial analysis of a company. They are the current, quick and cash ratios. All three measure a company's ability to meet its short-term obligations based on the liquid assets it currently has on hand. Liquidity ratios provide an indication of the overall financial health of the company, with implications regarding its ability to respond to an immediate liquidity crisis. They are also a measure of balance sheet risk.

Current Ratio

The current ratio is calculated by dividing current assets divided by current liabilities. Current assets are assets from which the benefits can be obtained within the upcoming fiscal year. Likewise, current liabilities are obligations that must be paid within the upcoming fiscal year. A current ratio higher than 1.0 is desirable, because this indicates that the company has sufficient short-term assets to meet all of its short-term obligations.

Quick and Cash Ratios

The quick ratio is similar to the current ratio, except it is calculated by dividing quick assets by current liabilities. Quick assets are a company's cash and cash equivalents, including accounts receivable and marketable securities such as publicly traded common stock. They are the company's most liquid assets, and reflect the funds a company can obtain within one or two days, if necessary. The quick ratio provides a more conservative, reliable estimate of a company's true ability to pay off its short-term liabilities. The cash ratio provides the most conservative estimate by only including cash and equivalents in the numerator.