Liquidity Ratios Guide

Liquidity ratios offer insight into a company’s ability to pay off debt obligations due in the next 12 months without raising outside capital, taking on a loan or making large operating cuts. Looking at these ratios provides information about how a company is performing.

A higher ratio means the company likely can cover its current and near-term debts. A lower ratio might mean the company is financially struggling.

Comparing the ratios to a company’s own historical performance or competing companies is most effective.

What are the main liquidity ratios?

  • Current Ratio takes a company’s current assets and divides them by current liabilities. It is a method of looking at a company’s ability to pay its short-term debts with its most liquid assets.

What is a good current ratio? 

A good current ratio should be 1 or higher — ideally, much higher. This would mean a company has more current assets than liabilities to cover its debts. A current ratio below 1 means the company’s liquid assets could not cover its upcoming bills.

  • Quick Ratio is similar to the current ratio but excludes inventories from the numerator. Inventory may not be as liquid as receivables and cash. This could cause a problem if a company is stuck with a large amount of unsold inventory.

What is a good quick ratio?

A quick ratio of more than 1 makes a company a better choice for an investment. The higher the quick ratio, the easier a company can pay its near-term debts using liquid assets.

  • FCF to Short-Term Debt Ratio reveals whether the company’s most recent cash flows could pay off the debt that’s due in the next 12 months.

What is a good FCF (free cash flow) to short-term debt ratio?

The higher the cash-flow-to-debt ratio is, the easier it will be for a  business to handle something unexpected or to take on more debt. Tracking the ratio year-over-year could give more information about how well a company manages its debts. The ratio should be compared with a company’s past performance or with industry competitors.

Liquidity ratios are an important consideration for investors as they show whether a company can pay its bills. High liquidity means a company has enough assets to pay its near term debts. A low liquidity ratio could mean a company is at risk for bankruptcy.

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