The formula to calculate the Liquidity Ratio is:
\[ LR = \frac{C + S + AR}{L} \]
Where:
Let's say a company has $50,000 in cash, $30,000 in marketable securities, $20,000 in accounts receivables, and $100,000 in total liabilities. The liquidity ratio would be calculated as follows:
\[ LR = \frac{50,000 + 30,000 + 20,000}{100,000} = 1 \]
So, the liquidity ratio is 1.
Liquidity ratio is a financial metric that assesses a company’s ability to meet its short-term obligations using readily available assets. It measures the company’s ability to convert its assets into cash quickly, without incurring significant losses, to cover its upcoming liabilities.
This ratio is crucial for businesses as it provides insights into their financial health and ability to handle financial obligations in the short term. By understanding the liquidity ratio, stakeholders such as investors, lenders, and suppliers can evaluate a company’s risk profile and make informed decisions about their engagement with the business.
A high liquidity ratio indicates that a company has sufficient liquid assets to meet its short-term liabilities comfortably. This implies a stronger financial position, as the company can readily settle its debts and operational expenses without resorting to external borrowings or selling fixed assets. A low liquidity ratio indicates a potential risk for a company. Having a smaller proportion of liquid assets in relation to its liabilities means that the company may face difficulties in fulfilling its short-term obligations. This could lead to liquidity constraints, delayed payments to suppliers, or even bankruptcy if the situation persists.