# Liquidity Ratio – Meaning, Formula, Types

by Angel One
The liquidity ratio analyses the company’s financial health with respect to short-term debts. Learn about liquidity ratios, their types, formula and how it is different from solvency ratios.

Liquidity refers to the company’s ability to meet its short-term obligations and convert its assets into cash quickly. Maintaining adequate liquidity is vital for the smooth functioning of operations, as it enables companies to cover expenses on a timely basis. To measure a company’s liquidity we use liquidity ratios. In this article, learn about liquidity ratios, their types, benefits, and how it is different from solvency ratios.

## What Are Liquidity Ratios?

The liquidity ratio measures the company’s ability to convert its assets to meet immediate debt requirements. The higher the liquidity ratio, the easier it is for the company to clear its short-term dues. The liquidity ratio is one of the key parameters any lender checks while offering loans to a company.

## Types of Liquidity Ratios

There are different types of liquidity ratios. Here are the four commonly used liquidity ratios.

1. ### Current Ratio

This refers to the company’s ability to clear its current liabilities with its current assets like cash, inventories, accounts receivable, etc. The current liabilities are the ones that need to be cleared within a year. If the current ratio is high, it means that the company’s liquidity position is better.

Current Ratio = Current Assets / Current Liabilities

2. ### Quick Ratio

This ratio is also known as the acid test ratio. It measures the company’s ability to clear its short-term debts with its most liquid current assets. Here inventories and prepaid expenses are not included. The higher the ratio, the better it is.

Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities

3. ### Cash Ratio

This ratio measures the company’s ability to pay off its short-term obligations by utilising liquid assets like cash and cash equivalents. If the ratio is high, it means that the company has a good amount of cash to clear the debts. Cash Ratio = Cash and Cash Equivalent / Current Liabilities

4. ### Net Working Capital Ratio

This ratio determines the company’s ability to continue its operations using sufficient cash or funds available. The high ratio indicates that the company is doing well in terms of its current assets. Net Working Capital Ratio = Current Assets – Current Liabilities

## What Is the Liquidity Ratio Formula?

There are different types of liquidity ratios and each one has a different formula. Here’s a table to list down the liquidity ratios formula.

 Liquidity Ratio Formula Quick Ratio (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities Current Ratio Current Assets / Current Liabilities Net Working Capital Ratio Current Assets – Current Liabilities Cash Ratio Cash and Cash Equivalent / Current Liabilities

## Example of Liquidity Ratios

Let us understand the liquidity ratios better with an example. Here is the balance sheet of XYZ Company. Let’s calculate the liquidity ratios of this company.

Assets

• Cash – Rs. 50 million
• Marketable securities – Rs. 25 million
• Accounts receivable – Rs. 100 million
• Inventory – Rs. 80 million
• Prepaid expenses – Rs. 60 million

Total current assets = Rs. 315 million

Liabilities

• Current liabilities – Rs. 80 million
• Long-term debt – Rs. 150 million
• Retained earnings – Rs. 35 million
• Total equity – Rs. 200 million

Total liabilities = Rs. 465 million

Now let’s calculate the liquidity ratios from this balance sheet of the XYZ Company.

• Current ratio = 315/80 = 3.9
• Quick ratio = (50 + 80 + 25)/80 = 1.9
• Cash ratio = (50 + 25)/80 = 0.94
• Net working capital ratio = 315 – 80 = 235

## Benefits of Liquidity Ratios

• Helps in assessing a company’s financial health and solvency by evaluating its ability to meet short-term obligations.
• Helps in understanding the risk position of a company.

## Solvency Ratios vs Liquidity Ratios

Solvency ratios and liquidity ratios are both financial ratios used to assess different aspects of a company’s financial health. Here’s a table to understand the difference between solvency ratios and liquidity ratios.

 Solvency Ratios Liquidity Ratios Measure a company’s ability to meet long-term debt obligations. Help evaluate potential bankruptcy or insolvency risks. Measure a company’s ability to meet short-term obligations. Focus on liquidity risk and cash flow management. Include debt-to-equity ratio, debt ratio, and interest coverage ratio. Include current ratio, quick ratio, cash ratio, and net working capital ratio. Analyse capital structure, leverage, and earnings to cover debt obligations. Analyse cash flow management, ability to convert assets into cash, and meet day-to-day expenses.

### Conclusion

Liquidity ratios provide valuable insights into a company’s short-term financial strength, risk profile, and cash management capabilities. These details can help you in making an informed investment decision. Before analysing a company, understanding your investment objectives and risk appetite is important. Get started with your investment journey only after a thorough understanding of the markets, industry and the company. Before all that, open a Demat Account for free with Angel One.

## FAQs

### What is a liquidity ratio?

Liquidity ratio is a key parameter that measures the company’s ability to convert its assets to meet its short-term debt requirements. It is used by investors and lenders to check the financial health of a company in terms of liquidity. It helps in analysing the cash flow management of a company and its ability to convert assets into cash to meet immediate expenses.

### How does liquidity differ from solvency?

Liquidity measures the company’s ability to meet short-term obligations by assessing its immediate cash availability and ability to convert assets into cash. Solvency, on the other hand, evaluates a company’s long-term financial stability and its ability to meet long-term debt commitments.

### How to calculate the liquidity ratio?

There are different types of liquidity ratios – current ratio, cash ratio, quick ratio and net working capital ratio. Using any of these ratios you can calculate the liquidity ratio of a company. All these ratios take different assets of the company into account.

### What if the company’s liquidity ratio is low?

If the liquidity ratio of the company is low, it means that the company does not have sufficient assets to cover its short-term obligations. This can lead to difficulties in meeting payment obligations and potential cash flow issues. This will also increase the chances for external financing. The company may need to take corrective actions such as improving cash management, reducing debt, or securing additional funding.

### Where do we get the financial information of a company?

The financial information of a company is found in its balance sheet, which can be on its official website.

### What is SLR?

SLR stands for Statutory Liquidity Ratio, which is the minimum percentage of deposits the Indian banks need to maintain. This can be in the form of cash, government securities and gold. As of February 2022, the current SLR is at 18% and is set by the RBI.