Liquidity ratios are one of the most important types of financial metrics used to figure out how well a debtor can pay off their debts without having to get more money.
The quick ratio, current ratio, and days sales outstanding are some of the most common liquidity ratios.
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How Do You Measure Liquidity?
Liquidity ratios are one of the most important types of financial metrics used to figure out how well a debtor can pay off their debts without having to get more money. In order to figure out a company’s ability to pay its debts and how safe it is, liquidity ratios look at things like how much money a company has and how much money it has leftover.
Getting To Know Liquidity Ratios
To be liquid, you must be able to turn your assets into cash quickly and cheaply. Most often, liquidity ratios can be used to compare two things. This may be an internal or an external study.
Internal analysis of liquidity ratios, for example, looks at multiple accounting periods that are all reported the same way. Analysts can keep track of changes in the business by comparing what happened in the past to what is happening now. In general, if a company has a higher liquidity ratio, it is more likely to be able to pay its debts.
The Different Types of Liquidity Ratios Out There:
The Current Ratio
The current ratio shows how well a company can pay off its current debts (debts that are due in the next year) with its total current assets, like cash, accounts receivable, and inventories. The higher the ratio, the better the company’s ability to pay its debts:
‘Current Ratio’ = ‘frac’ text ‘Current Assets’
text: text>Current Liabilities
Current Ratio = Current Debts
People who have money now
The Quick Ratio
The quick ratio looks at a company’s ability to pay its short-term debts with its most liquid assets, so it doesn’t include inventory in its current assets. A ratio called the acid-test ratio is also called this:
CL C+MS+AR = CL C+MS+AR
where:
C is cash and cash equivalents.
MS: securities that can be sold
AR stands for receivables.
CL stands for current debts.
Day Sales Outstanding
In business, “days sales outstanding” refers to how long it takes a company to get paid after making a sale. This figure is called “days sales outstanding.” If a business has a high DSO, it means that it’s taking too long to get paid and is putting money into debts. DSOs are usually calculated quarterly or once a year.
Conclusion
There are times when even healthy businesses can get into trouble with their short-term debts, like repaying loans and paying their employees. This is called a “liquidity crisis.” Most recently, the global credit crisis of 2007 to 2009 was the best example of a huge loss of money that affected everyone. Commercial paper, which is short-term debt that big companies use to pay for current assets and debts, was a big part of this financial crisis. To know more about, Accounting equations, click here.