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Liquidity Ratio

Liquidity ratios, also called solvency ratios or cash flow ratios, are a class of financial metrics used to measure a company's ability to pay off its short-term debts and obligations. These ratios provide investors and creditors with insight into a company's ability to meet its current liabilities without raising additional capital. Common liquidity ratios utilized by financial professionals include the quick ratio, current ratio, and days sales outstanding (DSOs).

The quick ratio, also known as the acid test, measures a company’s most liquid assets against its most current liabilities and can be calculated by dividing a company’s liquid assets by its total current liabilities. Liquid assets consist of any asset that can easily be converted into cash within 90 days, such as cash, marketable securities, and accounts receivable. Current liabilities are financial obligations that are expected to be paid within the current operating cycle and generally include accounts payable, accrued payroll, and taxes payable.

The current ratio, another popular liquidity ratio, is calculated by dividing a company’s total current assets by its total current liabilities. However, whereas the quick ratio only considers liquid assets, the current ratio includes all current assets such as inventory, prepaid expenses, and fixed assets. From a creditor’s perspective, a current ratio of at least 1:1 is usually viewed favorably, as it implies that a company should have enough current assets to cover its current liabilities.

Finally, DSO is a liquidity ratio widely used by creditors to determine if a company is paying its debts promptly. DSO is the average number of days required to collect payments from customers after those customers are invoiced. A higher DSO indicates a greater likelihood of having trouble collecting payments on sales, when compared to a lower DSO. Calculating DSO is easy: to do so, divide a company’s outstanding accounts receivable by its total credit sales and then multiply this figure by the number of days in the particular period.

In summary, liquidity ratios measure a company’s ability to cover its short-term debt obligations and cash flows, while solvency ratios measure a company’s ability to pay its bills over the longer-term. Investors and creditors place a great deal of emphasis on these ratio analyses, as the ratios can reveal potential areas of uncertainty and risk prior to an investment. Therefore, public companies should strive to maintain strong liquidity and solvency ratios by managing cash and current assets efficiently, paying off debts promptly, and raising additional capital if necessary.

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