Liquidity ratios are useful in evaluating the overall health of a business based on its near-term ability to keep up with debt. There are two distinct liquidity ratios that serve as a comparison between a company's short-term assets and current liabilities. These ratios are the current and quick ratios.
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Calculating Current Ratio
The current ratio is a simple division of current assets by current liabilities. Both of these numbers are typically reported on a company's periodic balance sheet. Current assets include balances in cash, marketable securities, accounts receivables and inventory. Current liabilities include debts and interest due within 12 months. If current assets in a given period total $400,000, and total debt in the same period equal $200,000, the current ratio is 2:1.
Current Ratio Interpretation
A current ratio above 1:1 is typically favorable, suggesting the business has good liquidity; however, a high ratio may mean a company isn't taking advantage of growth opportunities through debt. Any ratio below 1:1 suggests the company is highly leveraged in debt and may struggle to keep up with short-term payments. Interpretations vary depending on the industry and company. Death care services, property management and the grocery store industry have the highest
industry ratios, according to a December 2014 Forbes article. Thus, to be competitive in these sectors, a relatively high ratio is often needed. In contrast, discount retailer Walmart often maintains a ratio below 1:1 because it collects receivables and turns inventory quickly.
Calculating Quick Ratio
The quick ratio is similar to the current ratio, except that inventory balances are removed from the current assets total. Also known as the acid test, this liquidity ratio is a bit more useful in evaluating liquidity, since a company normally wouldn't want to liquidate inventory to pay debt. If $100,000 of the $400,000 in current assets is actually inventory, the quick assets equal $300,000. When you divide this amount by the current liabilities total of $200,000, you get a quick ratio of 3:2.
Quick Ratio Interpretation
A quick ratio of 1:1 suggests a stable financial condition. If your business has a ratio that is much higher, it may mean you aren't using your available cash or quick assets to drive business growth. On the other hand, a ratio below 1:1 suggests potential debt leverage concerns. Companies with ratios below this threshold often rely too much on inventory discounts or sales to generate cash for debt payments.