Liquidity Measurement Ratios

A company’s liquidity is its ability to meet its short-term financial obligations. Liquidity ratios attempt to measure a company's ability to pay off its short-term debt obligations. This is done by comparing a company's most liquid assets, those that can be easily converted to cash, with its short-term liabilities.

In general, the greater the level of coverage of liquid assets to short-term liabilities the better. A company with a low coverage rate should raise a red flag for investors as it may be a sign that the company will have difficulty meeting its short-term financial obligations, and consequently in running its day-to-day operations.

During hard times for the business or the economy, a company with insufficient liquidity might be forced to make tough choices to meet their obligations. These could include liquidating productive assets, selling inventory or even a business unit. These moves could prove detrimental to both the company’s short-term viability and their long-term financial health.

[ Liquidity ratios are a key part of fundamental analysis since they help determine a company's ability to service its debts. If a company fails to pay its debts, it could face bankruptcy or restructuring activity that could be detrimental to shareholder value. Investopedia's Fundamental Analysis Course discusses liquidity ratios and other financial ratios, along with financial statements and actionable fundamental strategies used by financial professionals in over five hours of on-demand video, exercises, and interactive content. ]

Liquidity ratios are based on different portions of the company’s current assets and current liabilities taken from the firm’s balance sheet.

We will look at the current ratio, quick ratios, the cash ratio and the cash conversion cycle as key measurements of a company’s liquidity.