{"id":3490,"date":"2021-11-07T16:25:06","date_gmt":"2021-11-07T22:25:06","guid":{"rendered":"https:\/\/finallylearn.com\/?p=3490"},"modified":"2023-08-19T14:22:48","modified_gmt":"2023-08-19T19:22:48","slug":"liquidity-ratios","status":"publish","type":"post","link":"https:\/\/finallylearn.com\/liquidity-ratios\/","title":{"rendered":"Liquidity Ratios"},"content":{"rendered":"\n<p class=\"has-text-align-left\"><strong>Liquidity ratios show the ability of a company to pay its short-term debts. The liquidity ratios include the current ratio, quick ratio, and cash ratio. <\/strong><\/p>\n\n\n\n<p class=\"has-text-align-left\"><strong>Liquidity ratios compare current assets and current liabilities to determine a company&#8217;s ability to pay its short-term debt.<\/strong><\/p>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_82_2 counter-hierarchy ez-toc-counter ez-toc-light-blue ez-toc-container-direction\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">Contents<\/p>\n<label for=\"ez-toc-cssicon-toggle-item-69eed061717e0\" class=\"ez-toc-cssicon-toggle-label\"><span class=\"ez-toc-cssicon\"><span class=\"eztoc-hide\" style=\"display:none;\">Toggle<\/span><span class=\"ez-toc-icon-toggle-span\"><svg style=\"fill: #999;color:#999\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" class=\"list-377408\" width=\"20px\" height=\"20px\" viewBox=\"0 0 24 24\" fill=\"none\"><path d=\"M6 6H4v2h2V6zm14 0H8v2h12V6zM4 11h2v2H4v-2zm16 0H8v2h12v-2zM4 16h2v2H4v-2zm16 0H8v2h12v-2z\" fill=\"currentColor\"><\/path><\/svg><svg style=\"fill: #999;color:#999\" class=\"arrow-unsorted-368013\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" width=\"10px\" height=\"10px\" viewBox=\"0 0 24 24\" version=\"1.2\" baseProfile=\"tiny\"><path d=\"M18.2 9.3l-6.2-6.3-6.2 6.3c-.2.2-.3.4-.3.7s.1.5.3.7c.2.2.4.3.7.3h11c.3 0 .5-.1.7-.3.2-.2.3-.5.3-.7s-.1-.5-.3-.7zM5.8 14.7l6.2 6.3 6.2-6.3c.2-.2.3-.5.3-.7s-.1-.5-.3-.7c-.2-.2-.4-.3-.7-.3h-11c-.3 0-.5.1-.7.3-.2.2-.3.5-.3.7s.1.5.3.7z\"\/><\/svg><\/span><\/span><\/label><input type=\"checkbox\"  id=\"ez-toc-cssicon-toggle-item-69eed061717e0\" checked aria-label=\"Toggle\" \/><nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#What-is-liquidity\" >What is liquidity?<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#What-do-liquidity-ratios-measure\" >What do liquidity ratios measure?<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#How-are-liquidity-ratios-computed\" >How are liquidity ratios computed?<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#How-do-we-interpret-liquidity-ratios\" >How do we interpret liquidity ratios?<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-5\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Summary-of-liquidity-ratios\" >Summary of liquidity ratios<\/a><ul class='ez-toc-list-level-3' ><li class='ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-6\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Ratio-Name\" >Ratio Name<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-7\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Ratio-Formula\" >Ratio Formula<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-8\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Ratio-Synonym\" >Ratio Synonym<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-9\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Ratio-Description\" >Ratio Description<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-10\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Ratio-Expressed\" >Ratio Expressed<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-3'><a class=\"ez-toc-link ez-toc-heading-11\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Ratio-Interpretation\" >Ratio Interpretation<\/a><\/li><\/ul><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-12\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Net-Working-Capital\" >Net Working Capital<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-13\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Current-Ratio\" >Current Ratio<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-14\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Quick-Ratio\" >Quick Ratio<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-15\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Cash-Ratio\" >Cash Ratio<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-16\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Burn-Rate\" >Burn Rate<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-17\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Days-Cash-on-Hand\" >Days Cash on Hand<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-18\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Limitation-False-Liquidity\" >Limitation: False Liquidity&nbsp;<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-19\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Opportunity-Cost-and-Liquidity-Ratios\" >Opportunity Cost&nbsp;and Liquidity Ratios&nbsp;<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-20\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Opportunity-costs-and-low-returns\" >Opportunity costs and low returns<\/a><\/li><li class='ez-toc-page-1 ez-toc-heading-level-2'><a class=\"ez-toc-link ez-toc-heading-21\" href=\"https:\/\/finallylearn.com\/liquidity-ratios\/#Opportunity-cost-example\" >Opportunity cost example<\/a><\/li><\/ul><\/nav><\/div>\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"What-is-liquidity\"><\/span>What is liquidity?<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>Liquidity is a financial concept about an asset\u2019s \u201cnearness to cash\u201d or the ease of converting an asset to cash.&nbsp;Cash is the most liquid asset.<\/p>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"What-do-liquidity-ratios-measure\"><\/span>What do liquidity ratios measure?<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>In financial analysis, liquidity ratios help determine whether an organization can pay its bills and maintain its normal business operations.&nbsp; Firms with insufficient liquidity may be unable to pay their employees, their suppliers, or their operating expenses in a timely manner.&nbsp;<\/p>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"How-are-liquidity-ratios-computed\"><\/span>How are liquidity ratios computed?<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>Liquidity ratios all involve comparing current assets and current liabilities in various ways. <\/p>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"How-do-we-interpret-liquidity-ratios\"><\/span>How do we interpret liquidity ratios?<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>For liquidity ratios, higher values indicate greater liquidity and therefore less risk. However, very high values may indicate inefficient management of current assets.<\/p>\n\n\n\n<p>Liquidity ratios are somewhat tricky to interpret.&nbsp; It is essential for organizations to have adequate liquidity, but it is undesirable to have too much liquidity.&nbsp; Too much liquidity may result in lower profits and lower returns since liquid assets usually have low rates of return.&nbsp;<\/p>\n\n\n\n<p>Therefore, with all liquidity ratios and metrics, both low and high ratio values raise red flags.&nbsp; The appropriate amount of liquidity can vary from one industry to another, so benchmarking and peer comparisons are important to identify the optimal amount of liquidity.&nbsp;<\/p>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<figure class=\"wp-block-image aligncenter size-large\"><img loading=\"lazy\" decoding=\"async\" width=\"1024\" height=\"547\" src=\"https:\/\/finallylearn.com\/wp-content\/uploads\/2021\/11\/liquidity-ratios-formulas-1024x547.webp\" alt=\"liquidity ratios formulas\" class=\"wp-image-3495\" srcset=\"https:\/\/finallylearn.com\/wp-content\/uploads\/2021\/11\/liquidity-ratios-formulas-1024x547.webp 1024w, https:\/\/finallylearn.com\/wp-content\/uploads\/2021\/11\/liquidity-ratios-formulas-300x160.webp 300w, https:\/\/finallylearn.com\/wp-content\/uploads\/2021\/11\/liquidity-ratios-formulas-768x410.webp 768w, https:\/\/finallylearn.com\/wp-content\/uploads\/2021\/11\/liquidity-ratios-formulas-1536x820.webp 1536w, https:\/\/finallylearn.com\/wp-content\/uploads\/2021\/11\/liquidity-ratios-formulas-2048x1094.webp 2048w\" sizes=\"auto, (max-width: 1024px) 100vw, 1024px\" \/><\/figure>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Summary-of-liquidity-ratios\"><\/span>Summary of liquidity ratios<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>The liquidity tables below contain the following information:<\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Ratio-Name\"><\/span>Ratio Name<span class=\"ez-toc-section-end\"><\/span><\/h3>\n\n\n\n<p>The most commonly used name of each ratio. <\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Ratio-Formula\"><\/span>Ratio Formula<span class=\"ez-toc-section-end\"><\/span><\/h3>\n\n\n\n<p>The preferred formula for computing this ratio.&nbsp;There may be more formulas for some ratios.&nbsp;We selected each formula based on our preference, simplicity, and common usage.<\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Ratio-Synonym\"><\/span>Ratio Synonym<span class=\"ez-toc-section-end\"><\/span><\/h3>\n\n\n\n<p>Any widely used alternate names or acronyms.<\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Ratio-Description\"><\/span>Ratio Description<span class=\"ez-toc-section-end\"><\/span><\/h3>\n\n\n\n<p>A brief description of the ratio.<\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Ratio-Expressed\"><\/span>Ratio Expressed<span class=\"ez-toc-section-end\"><\/span><\/h3>\n\n\n\n<p>A guide to how the ratio should be expressed. Note that many ratios are properly expressed as multiples, which have no units.<\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Ratio-Interpretation\"><\/span>Ratio Interpretation<span class=\"ez-toc-section-end\"><\/span><\/h3>\n\n\n\n<p>How to interpret the ratio results.&nbsp;Generally speaking, this shows how to understand higher values and lower values.&nbsp; Remember many ratios involve some type of tradeoff. So unambiguous directional interpretation can be difficult.<\/p>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Net-Working-Capital\"><\/span>Net Working Capital<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>Net working capital is a basic liquidity metric. The net working capital formula is current assets &#8211; current liabilities.<\/p>\n\n\n\n<figure class=\"wp-block-table aligncenter is-style-stripes\"><table><thead><tr><th>Net Working Capital<\/th><th class=\"has-text-align-center\" data-align=\"center\">Key Facts<\/th><\/tr><\/thead><tbody><tr><td>Formula<\/td><td class=\"has-text-align-center\" data-align=\"center\">Current assets &#8211;&nbsp;Current liabilities<\/td><\/tr><tr><td><meta charset=\"utf-8\">Synonyms<\/td><td class=\"has-text-align-center\" data-align=\"center\">Working capital<\/td><\/tr><tr><td>Description<\/td><td class=\"has-text-align-center\" data-align=\"center\">Basic liquidity measure; indicates how much current assets are<br>financed by \u201cpermanent\u201d sources of capital.<\/td><\/tr><tr><td>Expressed<\/td><td class=\"has-text-align-center\" data-align=\"center\">Dollars:  $1,234<\/td><\/tr><tr><td>Interpretation<\/td><td class=\"has-text-align-center\" data-align=\"center\">Higher = more liquid = less risky; too high = Inefficient<br>use of resources; should be positive for most firms<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<p><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Current-Ratio\"><\/span>Current Ratio<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>The <a href=\"https:\/\/finallylearn.com\/current-ratio\/\">current ratio<\/a> is the most common liquidity ratio. The current ratio formula is current assets \/ current liabilities.<\/p>\n\n\n\n<figure class=\"wp-block-table aligncenter is-style-stripes\"><table><thead><tr><th>Current Ratio<\/th><th class=\"has-text-align-center\" data-align=\"center\">Key Facts<\/th><\/tr><\/thead><tbody><tr><td>Formula<\/td><td class=\"has-text-align-center\" data-align=\"center\"><meta charset=\"utf-8\">Current Assets \/&nbsp;Current Liabilities<\/td><\/tr><tr><td>Synonyms<\/td><td class=\"has-text-align-center\" data-align=\"center\">Liquidity ratio; Working capital ratio<\/td><\/tr><tr><td>Description<\/td><td class=\"has-text-align-center\" data-align=\"center\"><meta charset=\"utf-8\">The most commonly used liquidity ratio.<\/td><\/tr><tr><td>Expressed<\/td><td class=\"has-text-align-center\" data-align=\"center\"><meta charset=\"utf-8\">Multiple:  1.23<\/td><\/tr><tr><td>Interpretation<\/td><td class=\"has-text-align-center\" data-align=\"center\">higher = more liquid = less risky; too high = Inefficient use of resources<br>the current ratio should probably be around 1.50-2.00 for most firms.<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<p><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Quick-Ratio\"><\/span>Quick Ratio<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>The quick ratio is a stricter test of liquidity. The quick ratio formula is (cash + receivables + marketable securities) \/ current liabilities. <\/p>\n\n\n\n<p>Marketable securities are short-term investments that can be sold anytime.<\/p>\n\n\n\n<figure class=\"wp-block-table aligncenter is-style-stripes\"><table><thead><tr><th>Quick Ratio<\/th><th class=\"has-text-align-center\" data-align=\"center\">Key Facts<\/th><\/tr><\/thead><tbody><tr><td>Formula<\/td><td class=\"has-text-align-center\" data-align=\"center\">(Cash + Receivables + Marketable Securities) \/&nbsp;Current Liabilities<\/td><\/tr><tr><td>Synonyms<\/td><td class=\"has-text-align-center\" data-align=\"center\">Acid-test ratio<\/td><\/tr><tr><td>Description<\/td><td class=\"has-text-align-center\" data-align=\"center\">Stricter test of liquidity.&nbsp;Inventory and prepaid items are<br>removed from the numerator since they are the <br>most illiquid of the current assets.<\/td><\/tr><tr><td>Expressed<\/td><td class=\"has-text-align-center\" data-align=\"center\">Multiple:  1.23<\/td><\/tr><tr><td>Interpretation<\/td><td class=\"has-text-align-center\" data-align=\"center\">higher = more liquid = less risky; too high = Inefficient use of resources<br>the quick ratio should probably 1.00 or higher for most firms.<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<p><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Cash-Ratio\"><\/span>Cash Ratio<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>The cash ratio is the strictest liquidity test. The cash ratio formula is (cash + marketable securities) \/ current liabilities. <\/p>\n\n\n\n<p>Marketable securities are also called short-term investments.<\/p>\n\n\n\n<figure class=\"wp-block-table aligncenter is-style-stripes\"><table><thead><tr><th>Cash Ratio<\/th><th class=\"has-text-align-center\" data-align=\"center\">Key Facts<\/th><\/tr><\/thead><tbody><tr><td>Formula<\/td><td class=\"has-text-align-center\" data-align=\"center\">(Cash + Marketable Securities) \/&nbsp;Current Liabilities<\/td><\/tr><tr><td>Synonyms<\/td><td class=\"has-text-align-center\" data-align=\"center\">&#8211;<\/td><\/tr><tr><td>Description<\/td><td class=\"has-text-align-center\" data-align=\"center\">Strictest test of liquidity.<br>Focuses only on truly liquid assets.<\/td><\/tr><tr><td>Expressed<\/td><td class=\"has-text-align-center\" data-align=\"center\">Multiple:  1.23<\/td><\/tr><tr><td>Interpretation<\/td><td class=\"has-text-align-center\" data-align=\"center\">higher = more liquid = less risky<br>too high = inefficient use of resources.<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<p><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Burn-Rate\"><\/span>Burn Rate<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<figure class=\"wp-block-table aligncenter is-style-stripes\"><table><thead><tr><th>Burn Rate<\/th><th class=\"has-text-align-center\" data-align=\"center\">Key Facts<\/th><\/tr><\/thead><tbody><tr><td>Formula<\/td><td class=\"has-text-align-center\" data-align=\"center\"><meta charset=\"utf-8\">Net cash used per month <br>(can also be stated per day, per week, etc.)<\/td><\/tr><tr><td>Synonyms<\/td><td class=\"has-text-align-center\" data-align=\"center\">&#8211;<\/td><\/tr><tr><td>Description<\/td><td class=\"has-text-align-center\" data-align=\"center\"><meta charset=\"utf-8\">Typically used by firms with negative cash flow.&nbsp;<br>Very commonly used in venture capital<br>to estimate funding needs.<\/td><\/tr><tr><td>Expressed<\/td><td class=\"has-text-align-center\" data-align=\"center\"><meta charset=\"utf-8\">Dollars per time period: $10,500 per month<\/td><\/tr><tr><td>Interpretation<\/td><td class=\"has-text-align-center\" data-align=\"center\"><meta charset=\"utf-8\">Higher = More Cash Usage = Higher Cash Needs<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<p><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Days-Cash-on-Hand\"><\/span>Days Cash on Hand<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<figure class=\"wp-block-table aligncenter is-style-stripes\"><table><thead><tr><th>Days Cash on Hand<\/th><th class=\"has-text-align-center\" data-align=\"center\">Key Facts<\/th><\/tr><\/thead><tbody><tr><td>Formula<\/td><td class=\"has-text-align-center\" data-align=\"center\"><meta charset=\"utf-8\">Cash \/ One-day cash requirement<\/td><\/tr><tr><td>Synonyms<\/td><td class=\"has-text-align-center\" data-align=\"center\">&#8211;<\/td><\/tr><tr><td>Description<\/td><td class=\"has-text-align-center\" data-align=\"center\"><meta charset=\"utf-8\">Used by nonprofits and other organizations with <br>uneven cash inflows to estimate how many more days<br>of operations can be funded from current cash.<\/td><\/tr><tr><td>Expressed<\/td><td class=\"has-text-align-center\" data-align=\"center\"><meta charset=\"utf-8\">Days: 12.34 Days<\/td><\/tr><tr><td>Interpretation<\/td><td class=\"has-text-align-center\" data-align=\"center\"><meta charset=\"utf-8\">Higher = More Days of Operations = Safer<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n<hr class=\"wp-block-separator has-css-opacity\"\/>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Limitation-False-Liquidity\"><\/span>Limitation: False Liquidity&nbsp;<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>The liquidity ratios all compare current assets to current liabilities in some way.&nbsp;Higher&nbsp;levels of current assets&nbsp;compared to&nbsp;current liabilities are typically interpreted as&nbsp;creating greater liquidity. However, in certain situations, this may not be true.&nbsp;<\/p>\n\n\n\n<p>Two&nbsp;of the current assets, inventory and accounts receivable,&nbsp;may be artificially high&nbsp;in&nbsp;some cases.&nbsp; Inventory may include the value of products that have little chance of being sold. This is due to obsolescence or lack of demand in the market.&nbsp; <\/p>\n\n\n\n<p>Accounts receivable may include the value of accounts that have little chance of being collected because of age or a variety of other factors.&nbsp;&nbsp;&nbsp;<\/p>\n\n\n\n<p>In short, it is possible that the inventory and accounts receivable numbers that influence&nbsp;most of the&nbsp;liquidity ratios&nbsp;are \u201coptimistic.\u201d&nbsp; Obviously, firms should write off inventory that cannot be sold and receivables that cannot be collected. However, firms may not always do this in a timely manner.&nbsp;<\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Opportunity-Cost-and-Liquidity-Ratios\"><\/span>Opportunity Cost&nbsp;and Liquidity Ratios&nbsp;<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>One of the challenges\u00a0in interpreting any of the liquidity ratios is that\u00a0it is possible to have too much liquidity. Higher values\u00a0for any of the\u00a0liquidity\u00a0ratios\u00a0indicate more liquidity and thus, lower risk.<\/p>\n\n\n\n<p>However, very high values may indicate&nbsp;that current assets are being managed inefficiently, thus reducing the firm&#8217;s returns.&nbsp;This is due to the opportunity cost of holding too many current assets.&nbsp;<\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Opportunity-costs-and-low-returns\"><\/span>Opportunity costs and low returns<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>This opportunity cost is caused by the low returns that current\u00a0assets\u00a0earn. This is compared to more productive long-term assets.<\/p>\n\n\n\n<ol class=\"wp-block-list\">\n<li>The rate of return on \u201ctrue\u201d cash is zero.&nbsp;<\/li>\n\n\n\n<li>The return on marketable securities is typically tied to short-term interest rates. However, these rates are usually low.&nbsp;<\/li>\n\n\n\n<li>The return on inventory is typically negative. This is due to obsolescence, theft, or damage.&nbsp;<\/li>\n\n\n\n<li>The rate of return on receivables is typically negative. Some accounts will not be collected.&nbsp;<\/li>\n<\/ol>\n\n\n\n<p>Due to these low returns, firms should try to minimize&nbsp;current&nbsp;assets as much as possible given the constraints of their business models and economic reality.&nbsp;&nbsp;Obviously, firms need to hold cash and inventory.&nbsp; However, holding excess current assets leads to inefficiency and opportunity costs.&nbsp;<\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span class=\"ez-toc-section\" id=\"Opportunity-cost-example\"><\/span>Opportunity cost example<span class=\"ez-toc-section-end\"><\/span><\/h2>\n\n\n\n<p>This opportunity cost is easy to show with a simple example.&nbsp; <\/p>\n\n\n\n<p>Assume we have two firms that are completely identical except for the total current&nbsp;assets.&nbsp;Basic financial information about the firms appears below:&nbsp;<\/p>\n\n\n\n<figure class=\"wp-block-table aligncenter is-style-stripes\"><table><thead><tr><th>Financial Data<\/th><th class=\"has-text-align-right\" data-align=\"right\">Firm A<\/th><th class=\"has-text-align-right\" data-align=\"right\">Firm B<\/th><\/tr><\/thead><tbody><tr><td>Current Assets&nbsp;<\/td><td class=\"has-text-align-right\" data-align=\"right\">$1,000&nbsp;<\/td><td class=\"has-text-align-right\" data-align=\"right\">$3,000&nbsp;<\/td><\/tr><tr><td>Fixed Assets&nbsp;<\/td><td class=\"has-text-align-right\" data-align=\"right\">4,000&nbsp;<\/td><td class=\"has-text-align-right\" data-align=\"right\">4,000&nbsp;<\/td><\/tr><tr><td>Total Assets&nbsp;<\/td><td class=\"has-text-align-right\" data-align=\"right\">5,000&nbsp;<\/td><td class=\"has-text-align-right\" data-align=\"right\">7,000&nbsp;<\/td><\/tr><tr><td>Net Income&nbsp;<\/td><td class=\"has-text-align-right\" data-align=\"right\">700&nbsp;<\/td><td class=\"has-text-align-right\" data-align=\"right\">700&nbsp;<\/td><\/tr><tr><td>Current Liabilities<\/td><td class=\"has-text-align-right\" data-align=\"right\">500<\/td><td class=\"has-text-align-right\" data-align=\"right\">500<\/td><\/tr><tr><td><\/td><td class=\"has-text-align-right\" data-align=\"right\"><\/td><td class=\"has-text-align-right\" data-align=\"right\"><\/td><\/tr><tr><td>Current Ratio<\/td><td class=\"has-text-align-right\" data-align=\"right\">2.00<\/td><td class=\"has-text-align-right\" data-align=\"right\">6.00<\/td><\/tr><tr><td>Return on Assets (ROA)*<\/td><td class=\"has-text-align-right\" data-align=\"right\">14.00%&nbsp;<\/td><td class=\"has-text-align-right\" data-align=\"right\">10.00%&nbsp;<\/td><\/tr><\/tbody><\/table><figcaption class=\"wp-element-caption\">*ROA = net income \/ total assets<\/figcaption><\/figure>\n\n\n\n<p>In the example above,&nbsp;Firm A has good liquidity with a current ratio of 2.00. Firm B has higher liquidity at 6.00.&nbsp;However, it is too high.&nbsp; It must hold more current assets, thus increasing its total assets. Increasing assets reduce its return on assets (ROA).&nbsp;<\/p>\n\n\n\n<p>It is difficult to determine the optimal amount of liquidity for a firm.&nbsp;&nbsp;However,&nbsp;there is a trade-off. More liquidity is safer. But, too much liquidity imposes opportunity costs on the firm through lower returns.&nbsp;<\/p>\n\n\n\n<p><\/p>\n\n\n\n<p><\/p>\n\n\n\n<p><\/p>\n\n\n\n<p><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Liquidity ratios show the ability of a company to pay its short-term debts. The liquidity ratios include the current ratio, quick ratio, and cash ratio. Liquidity ratios compare current assets and current liabilities to determine a company&#8217;s ability to pay its short-term debt. What is liquidity? Liquidity is a financial concept about an asset\u2019s \u201cnearness [&hellip;]<\/p>\n","protected":false},"author":1,"featured_media":3493,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[99],"tags":[],"class_list":["post-3490","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-financial-analysis"],"blocksy_meta":[],"brizy_media":[],"_links":{"self":[{"href":"https:\/\/finallylearn.com\/wp-json\/wp\/v2\/posts\/3490","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/finallylearn.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/finallylearn.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/finallylearn.com\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/finallylearn.com\/wp-json\/wp\/v2\/comments?post=3490"}],"version-history":[{"count":5,"href":"https:\/\/finallylearn.com\/wp-json\/wp\/v2\/posts\/3490\/revisions"}],"predecessor-version":[{"id":5234,"href":"https:\/\/finallylearn.com\/wp-json\/wp\/v2\/posts\/3490\/revisions\/5234"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/finallylearn.com\/wp-json\/wp\/v2\/media\/3493"}],"wp:attachment":[{"href":"https:\/\/finallylearn.com\/wp-json\/wp\/v2\/media?parent=3490"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/finallylearn.com\/wp-json\/wp\/v2\/categories?post=3490"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/finallylearn.com\/wp-json\/wp\/v2\/tags?post=3490"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}