Function

• The use of liquidity ratio provides information about a company's ability to meet short-term financial obligations. Liquidity ratio compares the amount of current assets to that of current liabilities, and any shortage of current assets poses a liquidity risk when immediate obligations are not paid promptly. Companies often keep enough current assets that are readily convertible to cash to cover any payments due on current liabilities. To avoid liquidity risk, money borrowed on a short-term basis should not be allocated for long-term uses.
  
  

Measurement

• Liquidity ratio generally is defined as current assets divided by current liabilities. In practice, there are specific ways of measuring liquidity depending on how liquid it is for the particular current assets being considered. The general liquidity ratio is the so-called current ratio, which measures the liquidity of the total current assets against current liabilities. But because certain current assets may be difficult to liquidate for cash, to further ensure the liquidity of the current assets, another liquidity ratio called quick ratio considers only the portion of the current assets that excludes inventory. The most conservative liquidity ratio is the cash ratio, which further excludes accounts receivables and consists of primarily cash and marketable securities.
  
  

Interpretation

• In general, the higher a specific liquidity ratio, the less risk it is for short-term creditors. Lenders, suppliers and others that extend short-term credit to a company often prefer a current ratio substantially in excess of 1.0, which represents a higher possibility that the company can repay their claims when due. Quick ratio and cash ratio are typically less than 1.0. For businesses that take a longer time to convert inventories to cash or collect receivables from customers, quick ratio or cash ratio may be better indicators of liquidity risk. On the other hand, however, companies may try to lower liquidity ratio to put more assets to work, instead of having them sitting idle as cash equivalents.
  
  

Misrepresentation

• Liquidity ratio is susceptible to misrepresentation by company management. Companies report their financial data on scheduled balance-sheet dates, and management can take deliberate steps before the reporting date to affect the amount of current assets, current liabilities or both and make the ratio appear better. For example, management can delay some of the purchases on account until after a balance-sheet date in an effort not to increase current liabilities and lower the current ratio.