Understanding Liquidity Ratios in Bookkeeping
Liquidity ratios measure how easily and comfortably a firm can pay its immediate financial obligations and exploit immediate short-term financial opportunities. For example, everything else being equal, the firm that’s sitting on a large hoard of cash (high liquidity) can more easily pay its bills and can take advantage of great opportunities that pop up. (If a competitor gets into trouble and wants to sell valuable assets at fire sale prices, a very liquid firm with great gobs of cash can more easily exploit such an opportunity.)
The current ratio liquidity measure compares a firm’s current assets with its current liabilities. A firm’s current assets include cash, inventory, accounts receivable, and any other asset that can or will be quickly turned into cash. Most small businesses don’t have much in the way of other current assets, although they may have some, such as short-term investments. Current liabilities include bills that must be paid in the coming year: accounts payable, wages payable, taxes payable, and — if you’re borrowing money on a long-term basis (such as through bank loans) — the principal portions of the coming year’s payment on a loan.
The following is the exact formula used to calculate the current ratio:
current assets/current liabilities
The following simple balance sheet gives you an example of how this current ratio formula works. This firm’s current assets equal $50,000, and their only current liability is $20,000 of accounts payable.
|Fixed assets (net)||270,000|
|S. Nelson, capital||200,000|
|Total liabilities and owner’s equity||$320,000|
To calculate the current ratio of this firm, you use the following formula:
This formula returns the value 2.5. Therefore, the value 2.5 is this firm’s current ratio.
Here is a general guideline concerning current ratios: A firm’s current ratio should be a value of 2 or higher. In other words, the firm’s current assets should be double or more than double the firm’s current liabilities.
Acid test ratio
Also known as the quick ratio, the acid test ratio is a more severe measure of a firm’s liquidity. However, it serves the same general purpose as the current ratio. The acid test ratio indicates how easily a firm can meet its current financial obligations and exploit any financial opportunities that pop up.
The following formula is used for calculating the acid test ratio:
(current assets - inventory)/current liabilities
For example, in the case of the business described by the balance sheet, you use the following formula to calculate the acid test ratio:
This formula returns the value 1.25. Therefore, the value of 1.25 is this firm’s acid test ratio.
Here is a guideline for acid test ratio: A firm’s acid test ratio should be a value of 1 or higher. In other words, the current assets after you subtract the inventory should provide enough money to pay the current liabilities.