Liquidity ratios measure a firm's ability to meet its short-term financial obligations by assessing how quickly it can convert assets into cash to pay bills. They indicate the company's capacity to generate cash promptly to cover current liabilities such as accounts payable and short-term debt
. Key liquidity ratios include:
- Current Ratio: Compares total current assets (cash, accounts receivable, inventory) to current liabilities. A higher ratio indicates better liquidity and ability to cover short-term debts
- Quick Ratio (Acid-Test Ratio): Similar to the current ratio but excludes inventory from current assets, focusing on the most liquid assets like cash and receivables. It provides a more stringent measure of liquidity
- Cash Ratio: The strictest ratio, comparing only cash and cash equivalents to current liabilities, showing the firm's ability to pay bills immediately without selling other assets
Additionally, the Days Sales Outstanding (DSO) ratio measures how quickly a company collects cash from sales, impacting liquidity by indicating the speed of cash inflows
. In summary, liquidity ratios do indicate how fast a firm can generate cash to pay its bills by evaluating the availability and convertibility of liquid assets relative to short-term obligations
