what are liquidity ratios 
liquidity ratios are a class of financial metrics used to determine a debtor s ability to pay off current debt obligations without raising external capital liquidity ratios measure a company s ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio quick ratio and operating cash flow ratio understanding liquidity ratiosliquidity is the ability to convert assets into cash quickly and cheaply liquidity ratios are most useful when they are used in comparative form this analysis may be internal or external for example internal analysis regarding liquidity ratios involves using multiple accounting periods that are reported using the same accounting methods comparing previous periods to current operations allows analysts to track changes in the business in general a higher liquidity ratio shows a company is more liquid and has better coverage of outstanding debts alternatively external analysis involves comparing the liquidity ratios of one company to another or an entire industry this information is useful in comparing the company s strategic positioning to its competitors when establishing benchmark goals liquidity ratio analysis may not be as effective when looking across industries as various businesses require different financing structures liquidity ratio analysis is less effective for comparing businesses of different sizes in different geographical locations with liquidity ratios current liabilities are most often compared to liquid assets to evaluate the ability to cover short term debts and obligations in case of an emergency types of liquidity ratiosthe current ratio measures a company s ability to pay off its current liabilities payable within one year with its total current assets such as cash accounts receivable and inventories calculations can be done by hand or using software such as excel the higher the ratio the better the company s liquidity position current ratio current assets current liabilities text current ratio frac text current assets text current liabilities current ratio current liabilitiescurrent assets the quick ratio measures a company s ability to meet its short term obligations with its most liquid assets and therefore excludes inventories from its current assets it is also known as the acid test ratio quick ratio c m s a r c l where c cash cash equivalents m s marketable securities a r accounts receivable c l current liabilities begin aligned text quick ratio frac c ms ar cl textbf where c text cash cash equivalents ms text marketable securities ar text accounts receivable cl text current liabilities end aligned quick ratio clc ms ar where c cash cash equivalentsms marketable securitiesar accounts receivablecl current liabilities another way to express this is quick ratio current assets inventory prepaid expenses current liabilities text quick ratio frac text current assets inventory prepaid expenses text current liabilities quick ratio current liabilities current assets inventory prepaid expenses days sales outstanding dso refers to the average number of days it takes a company to collect payment after it makes a sale a high dso means that a company is taking unduly long to collect payment and is tying up capital in receivables dsos are generally calculated on a quarterly or annual basis dso average accounts receivable revenue per day text dso frac text average accounts receivable text revenue per day dso revenue per dayaverage accounts receivable who uses liquidity ratios liquidity ratios are utilized by a variety of people there s one single purpose to liquidity ratios and their versatility makes them useful to a number of different users the following stakeholders in varying domains can each use liquidity ratios in distinct ways advantages and disadvantages of liquidity ratiosone of the primary advantages of liquidity ratios is their simplicity and ease of calculation this makes them accessible to investors creditors and analysts these ratios offer a quick snapshot of a company s liquidity position without delving into complex financial analysis for instance the current ratio which divides current assets by current liabilities can quickly be determined by glancing at a company s balance sheet another advantage of liquidity ratios is their utility in assessing a company s financial health and risk level a high liquidity ratio suggests that a company possesses sufficient liquid assets to handle its short term obligations comfortably a low liquidity ratio may signal potential liquidity issues though a company s financial health can t simply boil down to a single number liquidity ratios can simplify the process of evaluating how a company is doing liquidity ratios also facilitate comparison across companies and industries by benchmarking liquidity ratios against industry averages or competitors metrics stakeholders can identify strengths weaknesses and potential areas for improvement for instance you can compare microsoft s current ratio against google s current ratio to gauge how each company may be structured differently this can be an important part of deciding between companies to invest in especially if short term health is one of your primary considerations last liquidity ratios can communicate operational efficiency for instance a declining liquidity ratio may indicate deteriorating financial health or inefficient working capital management however it may also mean a company is trying to hold onto less cash and deploy capital more rapidly to achieve growth one drawback of liquidity ratios is that these ratios provide a static view of a company s liquidity position at a particular point in time this means they don t consider the dynamic nature of business operations and cash flows for example the current ratio may indicate sufficient liquidity based on current assets and liabilities but it doesn t account for the timing of cash inflows and outflows a company with high receivables and inventory turnover may have a healthy current ratio but struggle to convert these assets into cash quickly when needed as mentioned above under the advantages section liquidity ratios may not always capture the full picture of a company s financial health they focus solely on short term liquidity a company may maintain high liquidity ratios by holding excess cash or highly liquid assets which could be more effectively deployed elsewhere to generate returns for shareholders in addition a company could have a great liquidity ratio but be unprofitable and lose money each year last liquidity ratios may vary significantly across industries and business models though we listed comparability under the pro section there is also a risk that wrong decisions could be made when comparing different liquidity ratios for instance a capital intensive industry like construction may have a much different operational structure than that of a service industry like consulting comparing the liquidity ratios of different companies may not always be comparable fair or truly informative easy to calculate and understandprovides quick snapshot of liquidity positionhelps gauge financial stability and resiliencefacilitates comparison across companies and industries