The liquidity ratio measures the ability of a company to cover its short-term debts with available short-term assets, indicating the financial stability of the company.
The current ratio is the ratio of the company’s current assets to its current liabilities. With which, we can get an idea of the capacity of a company to face the payment of its debts in the short term.
Interpretation of the liquidity ratio
When the liquidity ratio is:
- Greater than 1: Ensures the facility to satisfy those debts and short-term obligations.
- Less than 1: There is a probability of a default on debt obligations.
Although it is true, all is said, that to compare two liquidity coefficients must be two companies in the same sector and comparable. Well, if we compare the liquidity ratio of a company belonging to a highly leveraged sector with a company from another sector that is not capital intensive, we can reach the wrong conclusions about their financial health.
Formula for the liquidity ratio
The current ratio measures current assets relative to current liabilities. In this way, the current ratio reveals the financial stability of a company.
The formula for the liquidity ratio is as follows:
Liquidity ratio = Current assets / Current liabilities
It is made up of two dividing elements. On the one hand, current assets (numerator) and, on the other, current liabilities (denominator).
Current assets, also called current assets, are the assets of a company that can be made liquid (turned into money) in less than twelve months.
Current liabilities or current liabilities, on the other hand, is the section of the liability that contains the short-term obligations of a company. That is, debts and obligations that have a duration of less than one year.
Example of the liquidity ratio
Company "A" reported current assets of $ 12 billion and current liabilities of $ 6 billion. On the other hand, company “B” reported a current asset of $ 3 billion and a current liability of $ 5 billion. Which company do you think has a better financial position considering the liquidity ratio analysis?
“A” Liquidity ratio = $ 12,000 / $ 6,000 = 2.0
“B” Liquidity ratio = $ 3,000 / $ 5,000 = 0.6
Considering the current ratio analysis, company "A" is more financially sound than company "B". But why do we know that? How is the data we have calculated interpreted? Let’s see it.
Company A has a current ratio of 2.0. That is, you can hedge your current liabilities for 2 times considering your current assets.
In contrast, Company B has a current ratio of 0.6. This indicates that with its current assets it can only cover 60% of its current liabilities.
Therefore, we will say that company "A" has a better liquidity situation than company "B". This, because it can face its debts and short-term obligations, more easily considering the use of its short-term assets of the company.
The current ratio is mostly used for banking institutions.