Liquidity ratios are measurements used to examine the ability of an organization to pay off its short-term obligations. Liquidity ratios are commonly used by prospective creditors and lenders to decide whether to extend credit or debt, respectively, to companies.
These ratios compare various combinations of relatively liquid assets to the amount of current liabilities stated on an organization's most recent balance sheet. The higher the ratio, the better the ability of a firm of pay off its obligations in a timely manner. Examples of liquidity ratios are:
- Current ratio. This ratio compares current assets to current liabilities. Its main flaw is that it includes inventory as a current asset. Inventory may not be that easy to convert into cash, and so may not be a good indicator of liquidity.
- Quick ratio. This is the same as the current ratio, but excludes inventory. Consequently, most remaining assets should be readily convertible into cash within a short period of time.
- Cash ratio. This ratio compares just cash and readily convertible investments to current liabilities. As such, it is the most conservative of all the liquidity ratios, and so is useful in situations where current liabilities are coming due for payment in the very short term.