How to assess a company's financial stability: liquidity ratio systems

Studying liquidity ratios is one of the most effective ways to assess whether an organization is capable of meeting its short-term financial obligations. These indicators provide investors and analysts with a clear picture of the company's financial flexibility and its ability to cope with unexpected financial challenges. At the same time, relying solely on these ratios should not lead to a final judgment about the overall position of the organization.

Three Key Indicators for Analyzing Short-Term Solvency

Liquidity ratios have three main types, each of which reveals different aspects of a company's ability to repay debts. While they are interrelated, they measure this potential at different levels of conservatism and detail.

Current liquidity ratio: basic level of analysis

It is worth starting with the most widely used indicator – the current liquidity ratio. It shows the extent to which current assets exceed current liabilities, or in simpler terms, how many assets correspond to one monetary unit of debt.

Calculated using the formula:

Current liquidity ratio = Current assets ÷ Current liabilities

The higher this indicator, the more comfortable the organization's position regarding debt repayment. However, such a liquidity ratio includes all types of assets without distinction, which can lead to misunderstanding, as some assets are more difficult to quickly convert to cash.

Quick liquidity ratio: a more conservative approach

The second indicator is used for a stricter assessment. The quick liquidity ratio, or so-called critical evaluation, only accounts for the most liquid assets – cash, easily sellable securities, and accounts receivable. Inventories and materials are not considered in this calculation, as they are harder to liquidate quickly.

The formula looks like this:

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

This liquidity ratio provides a more realistic view of how the company will handle urgent payments without drawing on reserves.

Money liquidity ratio: the strictest criterion

The most conservative option is the cash liquidity ratio. It takes into account only cash and cash equivalents, completely ignoring other assets.

Calculated as follows:

Liquidity Ratio = Cash ÷ Current Liabilities

Although this indicator is the strictest, it most objectively reflects the company's immediate ability to settle with creditors if a critical situation arises.

Interpretation of Results: What the Numbers Tell Us

Understanding how to read these indicators is key to proper analysis. An indicator that equals one signifies that assets and liabilities are balanced - the company has resources to cover debts without exceeding. If the result is below one, it is a signal of potential difficulties: the organization has insufficient assets to settle current debts.

The most acceptable scenario for the company and its investors is a value above one. This means that it has a sufficient margin of safety and is able to meet its financial obligations without strain.

However, one should not rely solely on these calculations. For a comprehensive assessment of the organization's condition, it is necessary to compare liquidity ratios with the indicators of competitors in the industry, analyze their changes over time, and consider them in the context of other financial indicators. Such a comprehensive approach will provide a true understanding of the financial strength and prospects of the company.