liquidity ratio

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The liquidity ratio shows the relationship between what a business possesses in terms of liquid assets (cash and cash equivalents) and the short-term liabilities to fulfill.

This ratio makes no distinction about the different due dates that the debts have, measuring the immediate capacity to pay back all short-term debts. liquidity ratio = liquid assets / short-term liabilities If the value of this ratio is greater than 1, the company is theoretically able to meet all their short-term liability obligations but the value of this ratio shouldn´t be very high since this ratio influences the general profitability of the business in an inverse way. That is to say, if the ratio is very high, the profitability will be reduced because this means that it is not using all of its capacity to contribute to the growth of the business. That being said, every business has its own situation depending on its activity which means that there is no concrete value that says which coefficient would be the best.

This ratio has a limited use so, in order to increase its utility, only the immediate liabilities due are taken for the denominator (if this value is known) instead of all the current liabilities. In this case, one would be comparing correlative patrimonial components: the money that is needed and what you have to pay in the moment; whose value should be greater than 1, otherwise a business could find itself in a theoretical situation of default. It is worth mentioning that in the case of the ratio being less than 1, this doesn´t necessarily mean that the business could not pay what they actually owe since you would have to take into consideration other elements of the current assets, meaning those which could quickly be converted into money if this were necessary, and the duration of the business´s cycle.

This situation would be considering a company´s portfolio of accounts receivable (and payable), the possibility of negotiating, the sale (even if under the normal price) of merchandise, using credit lines, the possibility of over-drafting credit or bank cards, obtaining a partial debt pardon, etc.


Live Chart: Latin America´s poverty reduction

Live Chart: Latin America´s poverty reduction