2. Liquidity Ratios

Liquidity ratios measure the firm's ability to quickly convert balance sheet accounts into cash. The three most prominent representatives of this group are the Current ratio, the Quick ratio, and the Cash ratio:

 

Current ratio = \( \frac{\text{Current assets}}{\text{Current liabilities}} \).

 

The current ratio indicates the number of times the firm's current assets cover its current liabilities

  

Quick ratio = \( \frac{\text{Cash} + \text{Accounts receivable}}{\text{Current liabilities}} \)

 

The quick ratio indicates the number of times the firm's cash and accounts reveivable cover its current liabilities.

 

Cash ratio = \( \frac{Cash}{\text{Current liabilities}} \).

 

The cash ratio indicates the number of times the firm's cash cover its current liabilities.

 

Not all current assets are equally easily converted into cash. For example, firms might find it difficult to liquidate their inventory if they urgently need cash, especially if the inventory in question is very firm specific. Therefore, the current ratio could provide a biased view of the company's ability to quickly get cash. This is why the quick ratio focuses on the current assets that can be most easily liquidated: Cash and accounts receivable. The quick ratio is often also referred to as Acid-test ratio. The most conservative liquidity ratio is the cash ratio, as it only includes actual cash holdings and ignores all current assets that first need to be liquidated before becoming available. The cash ratio is a particularly important liqudity ratio if there are bulk risks in the accounts receivable or if the firm grants its customers favorable payment terms.