Lesson 47 - Beginner accounting course

47. Liquidity Ratios: Current Ratio and Quick Ratio

Liquidity ratios measure a company's ability to meet its short-term financial obligations. Businesses need sufficient liquidity to pay off debts, cover operating expenses, and manage unexpected financial challenges. The two most commonly used liquidity ratios are the Current Ratio and the Quick Ratio.

1. What Are Liquidity Ratios?

Liquidity ratios analyze whether a company has enough liquid assets to cover its short-term liabilities. A higher ratio indicates stronger financial stability, while a lower ratio may signal potential cash flow issues.

The two main liquidity ratios are:

1. Current Ratio – Measures overall liquidity, including all current assets.

2. Quick Ratio (Acid-Test Ratio) – Measures immediate liquidity, excluding less liquid assets like inventory.

2. Current Ratio: Formula and Interpretation

The Current Ratio evaluates whether a company has enough assets to pay its short-term liabilities.

Formula:

• A ratio above 1 means the company has more assets than liabilities.

• A ratio below 1 suggests the company may struggle to meet short-term obligations.

• Ideal range: Between 1.5 and 2 (varies by industry).

Example:

• Company A has a strong liquidity position.

• Company B may face difficulties in paying short-term liabilities.

3. Quick Ratio: Formula and Interpretation

The Quick Ratio (also called the Acid-Test Ratio) is a more conservative measure. It excludes inventory and prepaid expenses, as these assets are not easily converted into cash.

Formula:

A ratio above 1 suggests strong financial health.

A ratio below 1 means the company may struggle to pay its immediate obligations.

Ideal range: Between 1 and 1.5.

Example: 

Company A has a healthy quick ratio, meaning it can pay off immediate liabilities.

Company B has a lower ratio, indicating potential liquidity risks.

4. Key Differences Between Current Ratio and Quick Ratio 

5. Why Are Liquidity Ratios Important?

• For Businesses: Helps in managing short-term financial health and planning for cash flow.

• For Investors: Indicates a company's ability to handle financial downturns.

• For Lenders: Determines the risk level before approving loans.

By regularly monitoring liquidity ratios, businesses can ensure financial stability and avoid cash flow crises.