Financial Ratios Series – Liquidity Ratios Part 1

“The world is changed by your example, not your opinion.” Paulo Coelho

Liquidity ratios are extremely important in the CMA exam. You will be heavily tested in this area. When I took the exam, I didn’t get any ratio question in the multiple answer section, but one of my essay questions asked me to calculate over 20 ratios for each of two companies. Now that was overwhelming! But if I could do it, I’m confident that you can too, with some practice.

Now, what are liquidity ratios? Before we can answer this question, let’s understand the term Liquidity. In a financial sense, liquidity is a descriptor used to categorize certain types of assets in a company. From a financial perspective, liquid assets are the kind that can be converted into cash rather quickly, within 12 months or less. These assets include:

  1. Cash & Cash Equivalents
  2. Marketable Securities
  3. Accounts Receivable
  4. Inventory
  5. Prepaid Assets

In a company’s balance sheet, liquid assets are placed in the Current Assets section, which is the first section on a balance sheet. Companies use their liquid or current assets to pay for short-term obligations such as payroll, material purchases, rent, interest, etc. It’s extremely important to keep a safe level of current assets in order to pay for current obligations, more formally known as current liabilities. These include:

  1. Accounts Payable
  2. Notes Payable – Short-Term
  3. Unearned Revenue
  4. Accrued Liabilities
  5. Current Portion of Long-Term Debt

In short, liquidity refers to a company’s short-term cash inflow and outflow.

Now that we have a clear understanding of what liquidity or liquid assets mean, let’s dive into liquidity ratios. 

Liquidity ratios are calculated to gain insight into a company’s ability to meet its short-term liabilities. To this end, a number of ratios were developed and are as follows:

  1. Current Ratio
  2. Quick/Acid Test Ratio
  3. Cash Ratio
  4. Working Capital
  5. Working Capital Ratio

We’ll look at each one individually throughout this liquidity ratios series. If you have any questions or comments about the material, don’t hesitate to use the comment section below to post them. I will respond to you as soon as possible.

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