The financial health of markets and businesses may be measured by their liquidity. Trades in liquid markets are conducted quickly and without hiccups, and spreads are reasonable. Therefore, to understand how financially healthy a specific company is, one should look at its liquidity ratio and compare it to industry standards. So, what is the liquidity ratio, and how do you calculate it?
What is the Liquidity Ratio?
The liquidity ratio measures the percentage of the company’s holding in cash, which measures its capability to deliver short-term obligations with available money without liquidating any assets.
This criterion checks a company’s performance, well-being, and financial status. Companies must keep a balanced cash reserve to pay their duties and to cushion it if the market goes sideways.
A good liquidity ratio is a good signal on a company’s financial statements that looks good for stakeholders, shareholders, and credit score, especially when a company wants to obtain loans and credit lines.
Calculating The Liquidity Ratio
Companies keep a balanced liquidity ratio calculation to monitor their financial situation. Liquidity ratio is calculated using its asset and current liabilities as: (Liquidity Ratio = Liquid Assets / Current Liabilities)
A healthy liquidity ratio varies between industries and market conditions. However, as a rule of thumb, organisations try to average a ratio of 2.0.
- Liquidity ratio < 1: the company will struggle to pay current obligations with cash because its liabilities are higher than assets.
- Liquidity ratio > 3: the company holds too much liquid cash and is not investing its holdings wisely.
Financial health and the capacity to meet short-term commitments with cash on hand or quickly liquidated assets are measured by liquidity ratios. Keeping your liquidity ratio in check attracts the attention of investors, creditors, and stakeholders, and it also indicates that your finances are in good shape.
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