After the company prepares its financial statements, extracting meaningful information and insight is essential. Out of this information and insights, decision-making follows. Hence, proper analytical procedures should be taken to understand your financial statement. One of the various ways to analyze your financial statements and make decisions out of it is the use of liquidity ratios.
Liquidity ratios will give you an idea of your business’s ability to pay off debts maturing within a year or the business’s next operating cycle. These ratios are important in assessing if you can pay all your current debts, which you used for your operations, using your current resources. Basically, you are determining your business’s ability to cover its short-term debts and have some idea of how successful it will be in continuing its current operations.
If you are unfamiliar with these ratios, Ripple VAs is here for you!
Here are three (3) liquidity ratios important for your business to succeed.
1. Cash Ratio
Cash ratio will examine your ability to pay off short-term debts using only your cash and cash equivalents. It is one of the most extreme measures of a business’s liquidity. You simply divide your cash and cash equivalents with your current liabilities to get the current ratio.
When you have one (1) or higher cash ratio, your business can cover its current debts using cash alone. If you have a result of less than one (1), it implies that you need to use other short-term assets to pay out your current liabilities fully.
2. Quick ratio
The quick ratio, also known as the acid test, will help you to gauge your business’s asset liquidity. Compared to the cash ratio, the quick ratio will use your quick assets (cash and cash equivalents, receivables, marketable securities) against your current liabilities to determine your ability to pay out your short-term debts.
If your quick ratio is one (1) or higher, your business won’t find it necessary to sell off any of your long-term assets to meet your current financial obligations. This is favorable because you are more likely to use your capital assets to generate income. And if you sell your capital assets, it will significantly affect the business’s finances. This will also give your investors a message that you cannot generate enough revenues from your regular operations to support your debts (which you use to operate).
3. Current Ratio
Unlike the more narrowly focused cash and quick ratios, the current ratio takes a broader view of the business’s liquidity by including other current assets like inventory in its calculations. Hence, the current ratio can be calculated by dividing your current assets by your current liabilities.
Generally, a current ratio of one (1) is the bare minimum as an acceptable level of liquidity. This result implies that no short-term assets would be left over after fully paying off your short-term debts. Ideally, your business should have a current ratio of (2) for a more comfortable buffer.
In conclusion, liquidity ratios will give you an idea of your business’s ability to take responsibility for your short-term debts while ensuring that after you paid off your debts, you can still continue operating. Liquidity ratios are also crucial in finding potential investors and retaining existing investors. Remember, the business’s success relies not only on your resources but also on how well you manage your responsibilities and how informed your decisions are.
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