Liquidity and the current ratio explained


Blue and Red
Liquidity is your ability to pay debts in the short-term (usually over the next 12 months).

To calculate liquidity, use the current ratio, calculated by dividing current assets by current liabilities (these both appear on the balance sheet).

As a general rule, a current ratio should exceed one, so that current assets exceed current liabilities.The higher the current ratio, the more liquid a company is.

If they are not able to meet their obligations as they come due, firms with poor liquidity can go bankrupt .

To determine whether a company has sufficient liquidity, you may wish to look at the current ratio over the past few years.  If it seems low (say, 80%), but has been running at this rate for the past few years, then the company probably has sufficient liquidity.

[Image: Blue and Red by Tambako the Jaguar, on Flickr]

About Mark P. Holtzman

Chair of Accounting Department at Seton Hall University. PhD from The University of Texas at Austin. Worked at Deloitte's New York Office. BSBA from Hofstra University.

Trackbacks/Pingbacks

  1. The balance sheet explained « Accountinator - March 28, 2012

    […] A Balance Sheet lists a company’s assets, liabilities, and owners” equity at a given point in time.  It follows the accounting equation and will help you understand a company’s solvency and liquidity. […]

  2. Transparency « Accountinator - April 18, 2012

    […]  It also requires understanding your books. Keep close tabs on your profitability, solvency, liquidity and productivity, and work to improve […]

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: