How to Evaluate a Company's Financial Health: Practical Guide on Liquidity

When you want to invest in a company or better understand its financial situation, one of the first things to check is: can it pay its accounts in the short-term? This is where liquidity ratios come in, essential tools for measuring this capacity. These indicators translate the immediate financial strength of an organization and help investors make more secure decisions.

The Three Financial Thermometers Every Investor Should Know

There are three main liquidity indices that serve as different barometers to assess short-term financial health. Each offers a unique perspective on how the company manages its money and financial obligations.

1. Current Liquidity: An Overview

This is the most comprehensive index. It compares the entire current asset (cash, inventories, accounts receivable) with the current liability (accounts payable, short-term loans).

Formula: Current assets ÷ Current liabilities

The higher this number, the better. A company with an index of 2, for example, has double the short-term assets to cover its obligations. It seems safe, right? But be careful: a very high index can indicate that the company is leaving money idle instead of investing in growth.

2. Dry Liquidity: More Conservative and Realistic

The quick ratio (, also called the acid-test ), is more stringent because it excludes inventories. Why? Because selling inventory takes time, and in a crisis, you might not be able to convert that into cash quickly.

Formula: (Available in cash + Negotiable securities + Accounts receivable) ÷ Current liabilities

This index provides a more realistic view of the company's immediate ability to meet its obligations without relying on quick sales of inventory.

3. Immediate Liquidity: Only Real Money

The most conservative of all. This index only considers the money that the company has in the bank at this moment.

Formula: Available cash ÷ Current liabilities

It is a very severe measure because rarely will a company have enough cash to cover 100% of its short-term obligations. Therefore, a lower ratio is generally expected here.

Interpreting the Numbers: What They Really Mean

When you calculate any of these liquidity indices, the result is a number that says a lot:

• Result = 1: The company has just enough to cover its obligations. It is balanced, but leaves little margin for safety.

• Result < 1: Concerning. The company does not have enough assets to cover its short-term debts. This does not mean automatic insolvency, but signals problems.

• Result > 1: Ideal. The company has financial leeway. The higher above 1, the greater the financial security, although very high numbers may suggest inefficiency.

Applying in Practice: Don’t Trust a Single Number Alone

Liquidity indices are powerful, but they are just part of the story. Combining them with other indicators—such as profitability, overall debt, and industry patterns—provides a complete view. A company with excellent current liquidity may have structural issues in other areas. Therefore, professional analysts always cross multiple metrics before making judgments.

Understanding current and non-current assets, and how they relate to your obligations, is essential for anyone who truly wants to understand the financial strength of an organization.