FMP
Nov 2, 2023 11:28 AM - Parth Sanghvi
Image credit: Markus Spiske
Liquidity Ratios are financial metrics that measure a company's ability to meet its short-term financial obligations. They are calculated using data from a company's financial statements, such as the balance sheet and income statement.
Liquidity ratios are important for investors and creditors because they provide insights into a company's financial health and solvency. They can also be used to compare companies within the same industry.
The three main liquidity ratios are:
Current ratio = Current assets / Current liabilities
A higher current ratio indicates that a company is more liquid and has a better ability to meet its short-term financial obligations.
Quick ratio = (Current assets - Inventory) / Current liabilities
A higher quick ratio indicates that a company is more liquid and has a better ability to meet its short-term financial obligations, even if it has to sell its inventory at a discount.
Cash ratio = Cash and cash equivalents / Current liabilities
A higher cash ratio indicates that a company is more liquid and has a better ability to meet its short-term financial obligations, even if it has to sell its other current assets at a discount.
Liquidity ratios should be interpreted in the context of the industry in which a company operates. For example, companies in industries with high inventory turnover, such as retail and consumer goods, typically have lower current ratios than companies in other industries.
It is also important to consider the company's historical liquidity ratios and any recent changes to those ratios. A sudden decline in a company's liquidity ratios could be a sign of financial distress.
Conclusion
Liquidity ratios are important financial metrics that investors and creditors can use to assess a company's financial health and solvency. A company with healthy liquidity ratios is more likely to be able to meet its short-term financial obligations and avoid bankruptcy.
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