Cash flow is a key component of any business, from large multinational corporations to small businesses. Maintaining solvency and liquidity is important for business sustainability and growth. A quick and comprehensive way of assessing your business’ cash flow is through the use of liquidity ratios. Liquidity ratios are used to determine a business’s ability to meet its short-term financial obligations, which are of particular concern to both owners and creditors of the business. This article explores how businesses can use these 3 liquidity ratios to analyze its financial position.
1. Current Ratio
Also known as the working capital ratio, the current ratio is calculated as the ratio of current assets to current liabilities. A current ratio of more than 1 means that the business has more current assets than liabilities; a ratio of less than 1 indicates that the business is holding more current liabilities than assets. Creditors prefer businesses with a higher working capital ratio, as this represents reduced risk. For shareholders, a lower working capital ratio signifies that the business is utilizing its assets for growth. Current ratios vary depending on the business and the industry it is in.
Current ratio formula = Current Assets / Current Liabilities
2. Cash Ratio
For the ultimate test of liquidity, the cash ratio only takes into the account cash and cash equivalents such as marketable securities. Accounts receivables and Inventory are stripped out of the cash ratio, which results in a highly conservative estimate of business liquidity. The cash ratio indicates the business’ ability to pay off its debts immediately if for any reason, its obligations are called in.
Cash ratio formula = Cash + Cash equivalents / Current Liabilities
3. Quick Ratio
Similar to the current ratio, the quick ratio is used to measure liquidity. Some analysts prefer to use the quick ratio instead of the working capital ratio as the latter includes the value of inventory, whereas the quick ratio does not. Stripping out inventory, which may be difficult to liquidate, quickly results in a more conservative estimate of liquidity. The quick ratio is also known as the acid test, and is calculated as current assets less inventory, divided by current liabilities.
Quick ratio formula = Current Assets – Inventory / Current Liabilities
Financial ratios are an essential tool for strategic planning. Using these liquidity ratios to analyze your company’s financial position can help position you for growth and long-term success.
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