Liquidity can be compared with blood flowing into human heart because the moment blood stops flowing in the heart the heart stops working, in the same way in the case of companies liquidity can be compared to blood and company can be compared to heart and moment the liquidity position of the company deteriorate the company will be in trouble. Liquidity is very important for any company because if the company is profitable and it has liquidity problems then it can create the wrong perception about the company in the minds of outsiders like creditors, shareholders, banks and so on. In order to manage the liquidity properly, a company should carefully analyze the various liquidity ratios carefully. In order to understand more about liquidity ratios, let’s look at various types or list of liquidity ratios –
- Current Ratio – Current ratio is calculated as Current assets/current liabilities where current assets include items like cash, debtors, inventory, bills receivables, and so on while current liabilities include items like sundry creditors, bills payable, outstanding expenses and so on. Ideally, companies like to maintain the current ratio of 2:1 where for every 1 dollar of current liability company has $2 of current assets.
- Liquid Ratio – Liquid ratio can be calculated as quick assets/ current liabilities where quick assets include all current assets except inventory and prepaid expenses and current liabilities include all current liabilities which are used in current ratio. An ideal liquid ratio is 1:1 because quick assets include all assets which can be quickly converted into cash in short span of time and that is the reason why in this type of ratio for every 1 dollar of current liability there is only 1 dollar of a quick asset is considered as ideal.
- Cash Ratio – Cash ratio is calculated as a total of cash, bank balance, marketable securities like stocks and mutual fund divided by current liabilities. Ideally, a company would want to have cash ratio greater or equal to 1 so that company can pay current liabilities anytime without delay. Cash ratio excludes items like stocks, bills receivables, prepaid expenses and other such items which take some time to convert into cash.
- Net Working Capital Ratio – Net working capital ratio is calculated as Working capital/Total Assets *100 where working capital is calculated as current assets less current liabilities and total assets include all types of assets whether its current assets like cash, sundry debtors, bills receivable or fixed assets like land, plant and machinery, building and other fixed assets. A higher ratio would imply that company has enough cash flow so as to pay liabilities on time while a lower ratio would be indicative of cash flow problem in the company.
As one can see from the above that liquidity ratio is very important and they are like echo machine where echo machine checks the well-being of the heart the liquidity ratios checks the well-being of the liquidity position of the company and detailed analysis of liquidity ratios along with other ratios can provide detailed insight into company’s financial as well as liquidity position.