Financial ratios provide the business with a method to evaluate its performance. Also, that is a way to compare the firm’s performance with similar businesses in the industry. The relationship between two or more elements of financial statements is measured by ratios.

Financial ratios can be divided as follows, under the broader classification.

• Liquidity Ratios
• Asset Management Ratios (Efficiency Ratios)
• Leverage Ratios (Debt Management Ratios)
• Profitability Ratios
• Valuation Ratios

Through this article, we discuss liquidity ratios.

What is the liquidity ratio?

The liquidity ratio measures a company’s ability to pay its short-term obligations using short-term assets. Under the liquidity ratio, the firm uses the current ratio, quick ratio, and cash ratio to measure its liquidity position.

Current Ratio

The current ratio measures a firm’s ability to pay off its short-term liabilities from its current assets. It helps investors and creditors to understand the liquidity of a company. Also, this ratio uses to determine how easily that company will be able to pay off its current liabilities.

The formula of the current ratio:

A higher current ratio is always more favorable than a lower current ratio because it shows the company can more easily make current debt payments. The ideal current ratio is 2.

Quick Ratio

The quick ratio measures the ability of a company to pay its current liabilities from only its quick assets. This is a good sign for investors and creditors. Creditors can know if they will be paid back on time through this ratio.

The formula of the quick ratio:

A higher quick ratio is more favorable for the company because it shows there are more quick assets than current liabilities. The ideal quick ratio is 1.

Cash Ratio

The cash ratio measures a firm’s ability to pay off its current liabilities with only cash and cash equivalents. Creditors are particularly interested in this ratio because they want to make sure their loans will be repaid.

The formula of the cash ratio:

A ratio above 1 means that all the current liabilities can be paid with cash and equivalents. A ratio below 1 means that the company needs more than just its cash reserves and equivalents to pay off its current debt.