A liquidity ratio indicates the readiness of a company to generate the funds required to meet its short-term obligations. Liquidity ratios, also known as working capital ratios, determine the relationship between current business assets and current liabilities. The current ratio, a form of liquidity ratio, is a direct comparison of the current assets to the current liabilities, with state securities bureaus requiring a 2:1 ratio for a company to sell stock. Often considered a better indicator of short-term solvency, the acid test or quick ratio subtracts inventory from current assets to determine the relative percentage of cash and cash equivalents to current liabilities. Some analysts use the operating cash flow ratio, defined as the revenue of the business operations minus the expenses compared to the current liabilities.
Stockholders and banks evaluating loan applications routinely scrutinize liquidity ratios with many loan contracts requiring the maintenance of a defined minimum liquidity ratio. In order to secure business loans, companies aim to improve their liquidity ratios by a specific balance sheet date. The current ratio can be enhanced by using cash to pay off a current debt immediately before the balance sheet date. Taking out a long-term loan to repay short-term debt is also effective in improving the current ratio. Other possibilities for increasing the company liquidity ratios include invoicing pending orders earlier to increase accounts receivable, delaying purchases to reduce accounts payable, converting the inventory to accounts receivable or cash, and appraising the year-end inventory at a higher value.
While a liquidity ratio provides a general estimate of short-term solvency, it can be misleading when taken as an absolute indicator of company health. These ratios are based on a conceptual liquidation of all of a company's current assets to meet all of its current liabilities, not on an operating company. On the other hand, the often-disregarded cash conversion cycle (CCC) provides critical data regarding a company's management efficiency as well as its ability to pay off current liabilities. The CCC assesses the speed at which the company converts its inventory into sales, collects on its accounts, and pays its vendors for goods and services. It is calculated by adding the length of time in days that a product sits in inventory to the time that it takes for the company to collect receivables minus the time it takes to pay its accounts payable, with a shorter cycle indicative of higher liquidity.
