Assessment of Corporate Financial Health: How Do Liquidity Ratios Work?

Liquidity ratios are fundamental financial metrics that determine whether a company can meet its short-term obligations. These metrics are critical in the investment decision-making process, as they provide a clear picture of the organization's financial flexibility and solvency.

Three Fundamentally Different Approaches to Short-Term Solvency

When assessing a company's financial stability, we can choose from three different liquidity ratios, depending on how strictly we want to examine its situation.

The first step: The comprehensive liquidity ratio

This ratio shows how sufficient the company's total current assets are to cover its short-term liabilities. Its formula is as follows:

Comprehensive liquidity ratio = current assets / short-term liabilities

This is the most introductory indicator for those who are getting acquainted with the concept of liquidity for the first time. A higher value indicates that the organization is in a better position to meet short-term payment obligations immediately.

The stricter examination: Quick rate or “acid test”

If we only want to consider the most liquid assets—that is, those resources that can be converted to cash in an instant—then the liquidity quick ratio is the right choice:

Quick ratio = (cash + marketable securities + receivables) / short-term liabilities

The essential difference of this indicator is that it does not include inventory, as it cannot be considered an immediately realizable asset. Thus, a more conservative picture of the actual liquidity situation is presented to us.

The most conservative approach: Cash coverage ratio

If we only take the actual cash balance into account, then the most restrictive liquidity ratio is obtained:

Cash Coverage = Cash Reserves / Short-term Liabilities

This indicator helps those who want to assess the company's solvency based on the strictest criteria.

Interpretation of the Numbers: What Do the Specific Values Mean?

After calculating the liquidity ratios, interpreting the result is the key issue. The value of the ratio can indicate three types of situations:

• If the value is exactly 1.0: The company's assets and liabilities are balanced. Theoretically, it can cover the short-term obligations, but there is no safety buffer.

• If the value is below 1.0: Potential problem: the organization has fewer liquid assets than needed to cover short-term liabilities.

• If the value is above 1.0: This is the ideal situation. The company has the capacity to meet its obligations and still has some reserves.

Aspects Necessary for Understanding the Complete Picture

Liquidity ratios alone, without other financial indicators such as profitability ratios, debt ratios, or asset turnover, do not provide a complete assessment. These metrics need to be interpreted in comparison with industry norms and based on the company's long-term trends in order for the investor to gain a true picture of the organization's financial situation.