Liquidity is defined as the ease and ability by which an asset or security can be converted into cash. For a business, liquidity is defined as its ability to meet short-term financial obligations. The more "liquid" a business is, the better able it is to meet such obligations. Calculating a company's liquidity is done using various financial ratios. These include the cash ratio, the quick ratio and the current ratio. Liquidity ratios can reflect a company's performance as well as its financial situation.
Instructions
1. Calculate the company's cash ratio. Using a calculator, add cash and any marketable securities together. Divide that number by current liabilities. The cash ratio uses only a company's most liquid assets: cash and cash equivalents. It determines a company's ability to immediately pay current liabilities if payment were demanded. The cash ratio indicates short-term liquidity by showing how a company can pay off current liabilities without the sale of inventory or the receipt of accounts receivable. The higher the cash-ratio number is, the better able a company can meet current financial obligations using its cash and cash equivalents.
2. Perform the "acid-test" or quick ratio by adding the company's cash, securities, accounts receivable and notes receivable together. Divide this number by the current liabilities. Another way to calculate the quick ratio is by subtracting inventory from the current assets and dividing by the current liabilities. If a company has a lot of assets tied up in inventory, it will be dependent on the sale of inventory to finance operations. If sales growth is not adequate enough to convert inventory into cash, this can force a company to find other sources of capital to maintain operations. Since the quick ratio removes inventory from its equation, only other more liquid assets are used to see if a company can meet short-term operating needs. The higher the ratio number, the more liquidity a company has.
3. Find the current ratio by dividing the current assets by the current liabilities. The lower the current ratio, the more liabilities a company has than assets. Short-term creditors prefer a high current ratio since it typically reduces the risk of default. A lower current ratio may be appealing to shareholders because more of a company's assets are invested in growing the business. According to the Motley Fool website, a current ratio of 1.5 or greater is a general rule for a company being able to meet short-term operating needs sufficiently.
