Liquidity Ratios

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Liquidity Ratios

Liquidity ratios are used to measure a company’s ability to pay its short-term debt obligations. To calculate them, assets are compared with short-term liabilities. A company's assets can be converted into cash more or less quickly and therefore three different we generally distinguish between three liquidity ratios.

Current Ratio

The current ratio measures the current assets of a company in relation to its current liabilities. It shows whether the company can pay its current liabilities with cash and cash equivalents. If a company's current ratio 1 is less than 1 (100%), it means, from a theoretical point of view, that the company does not have sufficient liquidity to meet its current liabilities. If it is equal to or greater than 1 (100%), it means that the company has the necessary liquidity to pay them. In Germany, Austria and Switzerland, a current ratio of 0.3 (30%) or higher is considered sufficient because most companies actively use their liquidity for economic purposes. Note that the current ratio is rarely used for the fundamental analysis of a company and its liquidity.

Quick Ratio

Quick ratio assesses the relationship between certain current assets (cash, accounts receivables, and marketable securities, but leaves out inventories for example). It is similar as the current ratio, in the sense that it also measures the company’s ability to pay its current liabilities, but stricter. In general, companies with a quick ratio of less than 1 (100%) should be conservative. On the contrary, companies with a too high quick ratio indicate that they are not using their assets in an appropriate way to achieve an optimal result. In this case, the company should look for measures to reinvest the money or use it in another productive way.

Cash Ratio

The cash ratio assesses the ability of a company to repay its short-term debts on time and only considers a company’s most liquid assets. A cash ratio of less than 1.2 (120%) may indicate that the company has taken on too much current liability on time in relation to its assets readily available to a company. If the cash ratio is below the industry average, it may indicate a high risk for the company. On the other hand, if the company's working capital is well above the industry average, this is also a bad sign, as it means that assets are not being fully used.

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