What is Liquidity Ratio? Definitions and Types Must Know!

Liquidity ratio according Investopedia is an important financial ratio that must be owned by a company or other stakeholders.

This is because this ratio will show the level of trust, reliability and validity of the company.

What is Liquidity Ratio?

Liquidity ratios are an important class of financial metric used to determine a debtor's ability to repay debt obligations.

The debtor in question is a party or company that makes debts, for example corporates, investors, suppliers, and so forth.

The debt that becomes the benchmark for the liquidity ratio is current debt (short term) without increasing external capital.  

The liquidity ratio is used to measure a company's ability to pay its debt obligations and margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio.

The greater the liquidity ratio owned by the debtor, the more reliable the company is. This is because the debtor is considered capable of paying off his debt without exception.

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Types of Liquidity Ratios

There are 3 types of liquidity ratios, namely: Current/current ratio (current ratio), fast ratio (quick ratio), and cash ratios (cash ratio) or commonly referred to as Days Sales Outstanding (DSO).

Current Ratio

The current ratio is a liquidity ratio that measures a company's ability to pay off its current obligations (paid within one year).

This includes total current assets such as cash, accounts receivable, and inventory. The higher the ratio, the better the company's liquidity position.

Current ratio calculations use this simple formula, namely dividing current assets with liability at the moment. Or briefly the formula is as follows:

Current Ratio = Current Assets/ Current Liabilities

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Quick Ratio

The quick ratio is used to measure a company's ability to meet short-term obligations (under 1 year) with its most liquid assets. 

The calculation does not include inventory of current assets so that it is truly the ability of the company. The calculation used is:

Quick Ratio: (C + Ms+ Ar) / Cl

Information: 

C = cash & cash equivalents

Ms = marketable securities

AR = Account Receivable

Cl = current liability

Calculation of the quick liquidity ratio can also use another formula, namely:

Quick Ratio = (Current Assets – Inventories)/ Current Liabilities

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Days Sales Outstanding (DSO)/ Cash Ratio

Outstanding Sales Days (DSO) refers to the average number of days it takes a company to collect payment after making a sale. 

A high DSO means that the company is taking too long to collect payments and is tying up capital in accounts receivable. 

DSO is generally calculated quarterly or annually with the following calculations:

DSO = Current Account Receivable/Current Liabilities

Or use the calculation of the cash ratio, namely:

Cash Ratio = Cash / Current Liabilities