4.6. Liquidity ratios

Current ratio

Companies have limited assets with enough liquidity to be converted into cash to pay the liabilities. Those current assets which include cash, bank deposits, debts and receivables could be easily converted into funds. The current ratio measures the ability to pay short-term financial obligations through short-term assets, thus it is an important measure of short-term liquidity. As such this is a concept that binds the concepts working capital and working capital requirement.

  • \(Current\ ratio=\frac{Current\ assets}{Current\ liabilities}\)

The current ratio helps investors and equity holders to identify its capacity to pay these commitments, thus avoiding shortages in cash: A ratio above 1 indicates that the company has more current assets than current liabilities.

The liquidity ratio is also indicative of the debt burden: if the company has a low liquidity ratio and has a significant debt burden, it means that future cash flows will potentially be used to pay debt service.

Quick ratio

Reduced liquidity is similar to general liquidity, however the current assets considered to be capable of being converted into cash is shorter: it is considered that inventories do not have sufficient liquidity for short term cash flows. Additionally, because inventories are essential for the normal productive cycle of the company, constant level of inventory may be required. Reduced liquidity resulting from this assumption that inventories cannot be converted into cash and cash equivalents short-term financial. As a result, reduced liquidity will always be lower than the General liquidity. It is a more demanding test to the company’s short term capabilities.

  • \( Quick\ ratio=\frac{Curret\ asset-inventory}{Current\ liabilities}\)

Another (stricter) way to define reduced liquidity ratio is through considering only the current assets that can be converted to cash within 90 days. These may include cash and bank deposits, short-term investments or marketable securities and accounts receivable are considered. Short-term investments or marketable securities include trading and available for sale that can be easily converted to cash within 90 days.