Liquidity ratios indicate the ability of the company to meet its short-term obligations, and help a financial analyst assess this aspect of a company’s performance from the results of a financial model or financial statements.
There are 2 common liquidity ratios that a financial modeler is likely to come across.
Current assets are those assets that will be realized as cash within the next 12 months. Current liabilities are those debts that are due for payment within the next 12 months. The current ratio gives an indication of whether the business will be able to pay its debts in the short term (i.e. the next 12 months). Clearly, this ratio should be as high as possible, and a prudent ratio is 2 : 1
Current ratio = Current assets / Current liabilities
The quick ratio, or acid test, focuses upon whether the business could pay its debts in the very short term – i.e. tomorrow, or next week. As stock cannot always be sold quickly it is removed from the calculation of current assets. Again, this ratio should be as high as possible, and a prudent ratio is 1 : 1
Quick ratio = ( Current assets less inventory ) / Current liabilities
Both the current ratio and quick ratio give an indication of future solvency problems – i.e. whether the business will be unable to pay its debts.
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