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.


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