Liquidity Ratios

Leverage ratio's provide investors and lenders with insight into a companies ability to meet its short term debt obligations.  We will be covering three of more popular leverage ratios; the current ratio, quick ratio, and cash ratio.  When we look at the ratios, you will see that the difference between them all lies in the assets that are used to perform the calculations. 

Current Ratio

The current ratio is used as a liquidity gauge and it simply divides current assets by current liabilities. In most cases, the higher the ratio, the better short term financial condition that the company has; however, there are exceptions.  Some consider this ratio a bit misleading because the reality of the situation is that companies cannot liquidate all of their assets and if they can, it will take time just like anything else.  Additionally, it is hard to place a value on assets that will have to go through liquidation.  It's still important to understand what makes up a companies assets to get a better idea of how liquid the assets really are.

Quick Ratio

By removing inventory, the quick ratio does a good job of filtering out the uncertainty that that is present in the current ratio by only including assets that are truly easier to turn into cash.  This is a more conservative way of analyzing the cash position of a company; the quick ratio is often referred to as the "acid test".  While the quick ratio is more targeted at understanding true liquidity, it doesn't fit that bill 100%.  Notice the AR, or accounts receivables portion in our formula below.  Again, a company may or may not receive those funds or may have to settle for less than the true AR balance would suggest.  This is one of the pitfalls of the quick ratio.

Cash Ratio

So now we move on to the most conservative ratio of them all; the cash ratio.  The cash ratio only includes the most liquid assets in its calculation, cash and cash equivalents such as securities or investments.  As you can see, the cash ratio basically gives us the ability of a company to pay their debts immediately, if need be.  It is very rare to find a company who will have enough cash or cash equivalents on hand to cover all of their liabilities; and this is not necessary; hording large amounts of cash on the balance sheet is not necessarily the best thing for a company to be doing.  In practice, this ratio is not used all that much, it sounds good in theory but companies are not expected to have an extremely high cash ratio.