Essential for Financial Checkup: Liquidity Formula and Interpretation of Three Major Ratios

Why follow liquidity indicators?

What happens when a company faces cash tightness? Many people think that as long as there are many assets on the books, it is safe, but what truly tests a company is its short-term debt repayment ability. That is why investors and creditors both follow liquidity ratios—these indicators can clearly reflect the true condition of the company during difficult times.

Liquidity formulas are not just a numbers game; they are the key to understanding a company's financial health. Through these indicators, you can determine whether a company is truly capable of paying its bills and short-term debts on time.

Three types of liquidity ratios, each with its own use

The strictest measure: absolute Liquidity ratio

Among all liquidity indicators, the absolute liquidity ratio is the most conservative, as it only considers cash. This ratio tells you how much short-term debt can be covered by the cash on the company's hands.

The calculation formula is very simple:

Absolute Liquidity Ratio = Cash and Cash Equivalents / Current Liabilities

Why so strict? Because only cash is truly available for immediate use. Inventory and accounts receivable are too slow.

Compromise plan: Quick ratio (acid test)

Quick ratio considers a slightly broader range of assets - it includes not only cash but also liquid assets. It excludes inventory because selling inventory takes time.

The calculation method is as follows:

Quick Ratio = ( cash + marketable securities + accounts receivable ) / current liabilities

This indicator is closer to reality, as most companies can indeed collect receivables or sell securities within a few days.

The most lenient assessment: Liquidity ratio

Liquidity ratio is the most commonly used one, as it includes all current assets, including inventory. This reflects the company's most optimistic ability to repay debts.

The formula is:

Liquidity Ratio = Current Assets / Current Liabilities

A liquidity ratio higher than 1 theoretically means that the company has enough assets to pay off its debts, but remember - there is a gap between theory and reality.

How to correctly understand these numbers?

What does it mean when a ratio equals 1? It means that a company's assets can just cover its debts – sounds good, but it's actually very dangerous because there is no buffer room.

When the ratio is less than 1, the situation is worse - the company's assets are insufficient to cover short-term debts, which is a warning sign.

The healthiest state is when the ratio is greater than 1, indicating that the company has a sufficient “margin of safety” and can respond calmly even in unexpected situations. However, it should not be too high—too high may indicate that the company is not effectively utilizing its capital.

Don't look at these indicators in isolation

The biggest mistake many people make is focusing on just one ratio to make decisions. Liquidity indicators are only part of the check-up; you also need to:

• Compare with industry standards (the normal level varies greatly across different industries)
• Check historical trends (Is the ratio rising or falling?)
• Combine with other financial indicators (profit margin, debt ratio, etc.)
• Consider the business cycle (data will vary between off-peak and peak seasons)

True financial analysis requires a comprehensive perspective—only by integrating all indicators can one accurately assess a company's real financial condition.