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Liquidity ratio

What is the Liquidity ratio?

The Liquidity Ratio is a major part of financial decisions and financial ratio analysis. With this ratio, companies (investors and creditors) know the actual financial status of the company so that they can find out if the company can pay short-term debts on time or not.

Inventories are the main calculation to find out the liquidity ratio because the company aim’s to complete the company’s inventories into cash. If inventory sales have to be more, the liquidity ratio has to be more also which will describe the efficiency of the company and how the company can pay and manage to cover short-term debts in a short time.

Types of Liquidity ratio

There are three types of liquidity ratio which are useful to calculate the financial position and strength of the company that describes the goodwill or reputation.

  • Current ratio
  • Quick ratio
  • Cash ratio

Benefits to calculate liquidity ratio

When investors and creditors come into financing, it is necessary to calculate some accounting ratios which measure the efficiency, strength, willpower, patience, sales percentage, profit margin, and so on.

The Liquidity Ratio is calculated based on current assets or inventory, without these, the company cannot find a liquidity ratio.

Find out actual financial performance

With this ratio, companies can find out the performance because the liquidity ratio has to be calculated only, how much the company can stand out against creditors by paying short-term debts regularly.

With this ratio, the company can make better of its working capital requirements

The Company can pay all short-term debts

If a company wants to know about the company’s financial performance so they have to calculate the ideal ratio because it depends on the liquidity ratio. This ratio tells you the investors and creditors, who stand for the company from the beginning to the end about whether the company can pay short-term debts or not and how quickly.

Better relation with financial institutions

If a company finds out an ideal ratio so management can have a better relationship with financial institutions which will increase the goodwill of the rich status of the company.

The Company’s strength depends on management and how much contribution management has towards the company’s strength because if a company will go to the financial institutions to get a loan for business inventory so creditors will first check their management involvement and financial background.

Ideal ratio 

Every ratio has an Ideal ratio and this ratio shows the company’s paying capacity of loans taken by lenders and other financial institutions and can cover all short-term loans or face any obstacles in the future. 

The current ratio is more than 1, so it means the company can pay off debts and go towards the liquidity of the company.

If the current ratio is less than 1 so it means the company has not enough ability to pay off debts.

In overall words, the ideal ratio checks the stability of the company that they can handle all the debts and can easily pay to the lenders or not.

Suppose if the current ratio is 1, it means the company is going on the right track but the balance of track can get worse anytime so it doesn’t count as an Ideal ratio.

Suppose if the current ratio is 2, it shows the higher sales of inventory that have a good impact on financial goodwill and status of the company.

Like the current ratio increases, the company will touch up and have a good financial background in front of financial investors.

Who analyzes the financial status of the company?

Investors and creditors have the most crucial part in analyzing the financial position of the company because both have equal position and status in the company but have one difference, investors are the people who spend their own money for company startup capital as a shareholder which counts as a foundation of a business. On the other hand, creditors are the people( banks or other financial securities, lenders) who provide money as a loan to the company against collateral and government securities such as cash, bonds, gold, house, etc. which count as securities to maintain a statutory liquidity ratio (SLR).

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