Aug 62 min read

Cash Flow or Cash Drowning? All You Need to Know About Liquidity Ratios

Many of us need to borrow money in certain situations. But will the bank approve our loan or not? Today, we'll learn what liquidity ratios are and their role in loan decisions.

What Exactly are Liquidity Ratios?

Liquidity ratios are indicators that measure a company's or an individual's ability to meet short-term financial obligations. Simply put, good liquidity means being able to afford and pay for something you need right now.

How Do We Ensure Strong Liquidity?

To assess your liquidity strength, you can calculate various liquidity ratios, such as:

Current Ratio: This ratio measures a company's ability to settle current liabilities (like bills and expenses) using its current assets (like inventory and accounts receivable).

Formula:

 Current Ratio = Current Assets / Current Liabilities

Quick Ratio: Similar to the current ratio, but it excludes inventory from current assets, making it a more conservative measure.

Formula:

 Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Example of Calculating Liquidity Ratios:

Let's take a simple example. A company has current assets of EGP 100,000, current liabilities of EGP 80,000, and inventory of EGP 30,000. We'll calculate both the current ratio and quick ratio for this company:

Current Ratio: EGP 100,000 / EGP 80,000 = 1.25 (generally acceptable)
Quick Ratio: (EGP 100,000 - EGP 30,000) / EGP 80,000 = 0.875 (generally acceptable)

How Can You Use Excel to Calculate Liquidity Ratios?

Excel allows you to calculate liquidity ratios easily. You can enter your asset and liability data in a spreadsheet and then use the formulas above to find the desired ratios.

When Can Liquidity Ratios Be Used?

Liquidity ratios are beneficial for the following:

Business Owners: To ensure their ability to meet short-term obligations and make sound financial decisions.
Investors: To evaluate investment risks in different companies.
Banks: To make decisions on approving loans for companies and individuals.

What Can You Learn from Liquidity Ratios?

Liquidity ratios tell us a lot about a company's or an individual's financial health, such as:

Ability to Meet Obligations: A high liquidity ratio signifies a greater ability to settle short-term liabilities.
Inventory Management: The quick ratio can indicate a company's efficiency in managing its inventory.
Financial Decision Health: Weak liquidity ratios might suggest poorly-considered financial decisions.

Are There Any Limitations?

Yes, there are limitations to consider with liquidity ratios:

Industry Variations: Acceptable liquidity ratios can vary depending on the industry.
Comprehensive Analysis: Relying solely on liquidity ratios isn't enough; a thorough financial analysis is needed for both companies and individuals.

In Conclusion,

Liquidity ratios are crucial indicators for business owners, investors, and banks. By calculating liquidity ratios, you can assess the financial strength of a company or individual and make better financial decisions.

Learn More about the lectures presented by Al-Assaal in the field of Excel, data analysis, and financial analysis

Know More

Income Statement Dashboard Engine

Buy Now