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Liquidity ratios show the ability of a company to pay its short-term debts. These include the current ratio, quick ratio, and cash ratio. Liquidity ratios compare current assets and current liabilities to determine a company's ability to pay its short-term debt. What is liquidity? Liquidity is a financial concept about an asset’s “nearness to cash” or the ease of converting an asset to cash. Cash is the most liquid asset. What do liquidity ratios measure? In financial analysis, liquidity ratios help determine whether an organization can pay its bills and maintain its normal business operations. Firms with insufficient liquidity may be unable to pay their employees, their suppliers, or their operating expenses in a timely manner. How are liquidity ratios computed? Liquidity ratios all involve comparing current assets and current liabilities in various ways. How do we interpret liquidity ratios? For liquidity ratios, higher values indicate greater liquidity and therefore less risk. However, very high values may indicate inefficient management of current assets. Liquidity ratios are somewhat tricky to interpret. It is essential for organizations to have adequate liquidity, but it is undesirable to have too much liquidity. Too much liquidity may result in lower profits and lower returns since liquid assets usually have low rates of return. Therefore, with all liquidity ratios and metrics, both low and high ratio values raise red flags. The appropriate amount of liquidity can vary from one industry to another, so benchmarking and peer comparisons are important to identify the optimal amount of liquidity. Summary of liquidity ratios The liquidity tables below contain the following information: Ratio Name The most commonly used name of each ratio. Ratio Formula The preferred formula for computing this ratio. There may be more formulas for some ratios. We selected each formula based on our preference, simplicity, and common usage. Ratio Synonym Any widely used alternate names or acronyms. Ratio Description A brief description of the ratio. Ratio Expressed A guide to how the ratio should be expressed. Note that many ratios are properly expressed as multiples, which have no units. Ratio Interpretation How to interpret the ratio results. Generally speaking, this shows how to understand higher values and lower values. Remember many ratios involve some type of tradeoff. So unambiguous directional interpretation can be difficult. Net Working Capital Net working capital is a basic liquidity metric. The net working capital formula is current assets - current liabilities. Net Working CapitalKey FactsFormulaCurrent assets - Current liabilitiesSynonymsWorking capitalDescriptionBasic liquidity measure; indicates how much current assets arefinanced by “permanent” sources of capital.ExpressedDollars: $1,234InterpretationHigher = more liquid = less risky; too high = Inefficientuse of resources; should be positive for most firms Current Ratio The current ratio is the most common liquidity ratio. The current ratio formula is current assets / current liabilities. Current RatioKey FactsFormulaCurrent Assets / Current LiabilitiesSynonymsLiquidity ratio; Working capital ratioDescriptionThe most commonly used liquidity ratio.ExpressedMultiple: 1.23Interpretationhigher = more liquid = less risky; too high = Inefficient use of resourcesthe current ratio should probably be around 1.50-2.00 for most firms. Quick Ratio The quick ratio is a stricter test of liquidity. The quick ratio formula is (cash + receivables + marketable securities) / current liabilities. Marketable securities are short-term investments that can be sold anytime. Quick RatioKey FactsFormula(Cash + Receivables + Marketable Securities) / Current LiabilitiesSynonymsAcid-test ratioDescriptionStricter test of liquidity. Inventory and prepaid items areremoved from the numerator since they are the most illiquid of the current assets.ExpressedMultiple: 1.23Interpretationhigher = more liquid = less risky; too high = Inefficient use of resourcesthe quick ratio should probably 1.00 or higher for most firms. Cash Ratio The cash ratio is the strictest liquidity test. The cash ratio formula is (cash + marketable securities) / current liabilities. Marketable securities are also called short-term investments. Cash RatioKey FactsFormula(Cash + Marketable Securities) / Current LiabilitiesSynonyms-DescriptionStrictest test of liquidity.Focuses only on truly liquid assets.ExpressedMultiple: 1.23Interpretationhigher = more liquid = less riskytoo high = inefficient use of resources. Burn Rate Burn RateKey FactsFormulaNet cash used per month (can also be stated per day, per week, etc.)Synonyms-DescriptionTypically used by firms with negative cash flow. Very commonly used in venture capitalto estimate funding needs.ExpressedDollars per time period: $10,500 per monthInterpretationHigher = More Cash Usage = Higher Cash Needs Days Cash on Hand Days Cash on HandKey FactsFormulaCash / One-day cash requirementSynonyms-DescriptionUsed by nonprofits and other organizations with uneven cash inflows to estimate how many more daysof operations can be funded from current cash.ExpressedDays: 12.34 DaysInterpretationHigher = More Days of Operations = Safer

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Financial Terms Glossary

Finance

Excel

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Financial Terms
Glossary