Liquidity indicators: how to assess a company's financial stability

Liquidity indicators are key financial metrics that allow investors and creditors to assess an organization's ability to meet its short-term obligations. They provide a clear picture of whether the company has sufficient liquid assets to cover debts in the near future. Without understanding these indicators, it is impossible to objectively judge the financial condition and solvency of the company.

Three main types of liquidity indicators

Financial analysis specialists use several indicators to assess a company's ability to meet short-term obligations. Each of them reveals different aspects of liquidity and has its own area of application.

Current liquidity ratio

This indicator shows the ratio between all of the company's current assets and its current liabilities. It provides the most general picture of solvency:

Current liquidity ratio = Current assets / Current liabilities

The higher the result, the more financial stability the organization has to fulfill its debt obligations.

Quick Liquidity Ratio

Unlike the previous indicator, this coefficient takes into account only the most liquid assets of the company, excluding material production stocks. The formula includes cash, securities, and accounts receivable:

Quick Liquidity Ratio = (Cash + Liquid Securities + Accounts Receivable) / Current Liabilities

This indicator is considered more conservative, as it does not rely on the quick sale of tangible assets.

Money liquidity coefficient

The strictest of all indicators considers only the company's cash reserves relative to its current liabilities:

Liquidity Ratio = Cash on Hand / Current Liabilities

Although this indicator is the most conservative, it is often considered the most accurate indicator of true solvency.

How to Interpret the Total Liquidity Ratio

Understanding the meanings of these indicators is critically important for an accurate assessment of risk. If the ratio equals one, the company possesses assets sufficient to precisely cover current liabilities without a deficit or surplus.

When the ratio is less than one, it signals potential problems – there are not enough assets to cover debts without raising additional funds.

The ideal scenario is a ratio above one. This indicates that the company can comfortably meet its obligations and still have a reserve for unforeseen expenses. However, the current liquidity ratio should be analyzed alongside other financial indicators, industry benchmarks, and time-based trends to get a complete picture of the organization's financial health.