Treasury Practice

Liquidity ratios

Published: Jun 2004

In the current economic climate, companies are rightly concerned with their working capital. Over recent years, the treasurer has become more central to working capital management in many organisations. There are a number of key ratios which provide an easy method of evaluating the relative importance of working capital to a company.

  1. The Current ratio  This is defined as\( \frac{Total\: current \:assets}{ \:Total\: current \:liabilities} \:\) Current assets include all the assets which the company can translate into cash within twelve months. Current liabilities include all liabilities which are required to be paid within twelve months. Therefore, the current ratio provides a good, but crude, indication of the company’s liquidity. A current ratio lower than 1 suggests that the company may have liquidity problems. The company will need to examine whether it needs to take action to ensure that it has sufficient cash to meet its obligations when they arise.
  2. The Quick ratio This is defined as \( \frac{ Total\: current\: assets \: - \: inventory }{Total \: current\: liabilities}\:\) This is sometimes referred to as the ‘acid test’ ratio. This may give a more accurate impression of the company’s liquidity. This is because the quick ratio recognises the fact that it can take some time to translate the company’s inventory into cash. The relative importance of the current ratio rather than the quick ratio depends on the nature of the company’s business and its ability to translate stock into cash.
  3. The Cash ratio This is defined as\(\frac{ cash\:  + \: short-term \: securities }{Total \: current\: liabilities}\:\)In some cases, the company will only want to consider the assets which are readily available to meet payment obligations. This ratio measures whether the company has cash or near-cash assets to meet its short-term liabilities.

All these ratios ignore the company’s ability to borrow additional funds. Because of this, these ratios provide a worst case scenario, which will be important when a company evaluates its liquidity.

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