The Liquidity ratio specifies the liquidity condition of the company and provides the capability of the company to pay all the short term obligations. This also specifies if the company has enough cash or not to meet its short term liabilities. The mainly used liquidity ratios are Current Ratio, Quick Ratio and Cash Ratio.
Current Ratio is the main liquidity indicator of a company which is measured by
Current Ratio = (Current Assets/ Current Liabilities)
The current assets and liabilities are already explained in the earlier part of this section. The current ratio denotes whether the company has enough current assets to pay its current liabilities or not. The more the current ratio, it is better for the company. Though the actual preferred value depends on the industry the company belongs to, it has to be more than 1.
Current assets consist of fixed assets which can not be converted to cash very easily. That’s why another important ratio is used to measure the liquidity of a company called Quick Ratio. The Quick Ratio or Acid-Test Ratio is another liquidity indicator of a company which measures the most liquid assets to check the liquidity.
Quick Ratio = (Cash and Cash equivalents + Account Receivables +
Available for sale investments)/ Current Liabilities
The quick ratio is much more conservative than the current ratio and it provides a much better picture about the liquidity condition of a company.
Quick Ratio is further modified to Cash Ratio which uses only cash as the measurement of liquidity of a company. It removes the account receivable from the asset section as it not equivalent as cash and receiving the same depends on the debtor turnover time.
Cash Ratio = (Cash and Cash Equivalents + Available for sale securities)
/ Current Liabilities
All these ratios measure the liquidity condition of the company. All the creditors check for these ratios before lending money to the company as higher liquidity ratio increases confidence to refund back the money on time.
Cash Conversion Cycle refers to the length of time the company takes to generate the cash investment in inventories and other goods to back into cash again. The cycle includes use cash to buy inventories or raw materials, develop the end product using the inventories, sell them in the market and get the cash back from the buyers. The cash conversion cycle is calculated as
Cash Conversion Cycle = (Days take to sell all the products + Days take to use all the inventories in stock – Days take to pay cash to all the suppliers)
Lower cash conversion cycle represents quick generation of cash from the business and higher liquidity position of the company. Higher cash conversion cycle is considered to be very bad as the company’s production and business system is not efficient enough to generate cash within proper timeframe.