Section: 2 Financial Ratio Analysis

Sub Section: 2 Liquidity Ratios

Liquidity is defined as the ability of a business to generate cash, and liquidity ratios measure the ability to pay off obligations as they mature. Short-term liquidity is the ratio of current assets to current liabilities of a company.  Following ratios are computed to measure short-term liquidity:


Current Ratio

This measures the ability of a company to pay its current liabilities such as accounts payables, short-term notes payables etc.  Current liabilities are used as denominators as they represent most urgent debts maturing within an operating cycle or one year which ever is longer.  Current assets, representing most liquid assets are taken as numerator for meeting those liabilities.  The current ratio can be calculated as follows:



Current Assets

Current Liabilities


This ratio is a good barometer to measure short-term liquidity but it has some limitations.  Some items such as prepaid expenses represent early settlement of future liabilities and are not potential sources of cash.  Similarly, accounts receivable and inventories may not be truly liquid.  Some companies with very high current ratios may not be able to meet their current liabilities,  due to inferior quality of accounts receivable (may be a result of loose credit policy) or slow moving inventories which can only be sold at discounted prices.  Thus it is necessary to use some other measure in conjunction with the current ratio such as cash flow from operations and liquidity of other assets.


Quick Ratio

Quick Ratio or Acid test ratio is similar to the current ratio, except it provides a more rigorous test of short-term liquidity of the company.  As mentioned earlier, prepaid expenses, store and spares and inventory may not have high liquidity.  For this reason less liquid current assets are excluded from the numerator.



Cash + Marketable Securities + Account Receivable

Current Liabilities


Cash Flow Per Share

Cash flow is crucial for the day-to-day running of business activities and it is closely linked to the long-term survival of the organization. Profitability does not guarantee cash flow, therefore it's prudent to give due consideration to cash flow management. Cash flow per share measures the liquid cash and cash equivalents in a business in per share terms.   



Net Income plus Non-cash Adjustments

Number of Shares Outstanding


Operating Cash Flow Ratio

This cash flow ratio measures the ability of the firm to generate operational cash to meet current liabilities as they fall due. Operational cash flow depends upon the nature of the industry, and some industries generate substantial cash flows. Therefore, conclusions should be made after referring to industry data.



Operating Cash Flow

Current Liabilities   


Cash Flow to Total Debt Ratio

This ratio indicates the cash flow available to cover total debt obligation of the company. Banks and long-term debt holders would be interested in this ratio as it provides insight to the company’s ability to repay the future debt obligations.



Cash Flow from Operations

Total Debt