How to use liquidity ratios to assess financial stability

Liquidity ratios are a key tool for analyzing a company's ability to meet its financial obligations in a timely manner. For investors and creditors, these indicators provide a clear understanding of the organization's financial stability and whether it can handle unexpected expenses.

The Three Main Types of Liquidity Ratios

Financial analysts use three main indicators to assess a company's short-term solvency. Each of them addresses the issue from different angles and together they provide a complete picture of the financial status.

Current liquidity ratio: a basic indicator of solvency

The current liquidity ratio is the simplest and most common indicator, calculated as the ratio of current assets to current liabilities:

Current liquidity ratio = Current assets / Current liabilities

This indicator provides a general idea of whether a company has enough short-term resources. The higher the value, the more comfortable the organization's liquidity position. However, an excessively high value may indicate inefficient use of capital.

Quick liquidity ratio: a more accurate assessment

The quick liquidity ratio (, also known as the critical assessment ratio ), provides a more conservative forecast. It takes into account only the most liquid assets, excluding inventories and other slowly realized assets:

Quick liquidity ratio = (Cash + Securities + Accounts receivable) / Current liabilities

Unlike the current liquidity ratio, this indicator does not take inventory into account, as stocks require time to sell. This approach provides a more realistic assessment of the company's ability to meet its debts immediately.

Liquidity ratio: the most conservative option

The money liquidity ratio is the strictest indicator, as it only takes into account cash reserves:

Liquidity Ratio = Cash on Hand / Current Liabilities

This indicator shows what portion of its obligations the company can cover with available cash without additional asset operations.

How to properly interpret the results

Understanding liquidity ratios requires a qualified reading of the numbers. When the ratio value equals 1, it indicates an ideal balance – assets exactly cover liabilities. If the value is less than 1, the organization does not have enough short-term assets. If the value is greater than 1, this is the most favorable situation, as the company has a reserve for safe debt coverage.

However, one should not rely solely on a single ratio. For an objective assessment of the organization's condition, these indicators should be analyzed together with other financial metrics, industry benchmarks, and the dynamics of changes over time. Such a comprehensive approach will give you the most accurate insight into the financial stability of the company and its ability to cope with short-term challenges.