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How is liquidity measured?

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Working capital, which is current assets in excess of current liabilities, measures a firm’s debt-paying ability and liquidity in absolute terms:

Current Assets − Current Liabilities

Any ratio used in evaluating a firm’s ability to pay its short-term debts with current assets is a liquidity ratioLiquidity ratios are of particular interest to those extending short-term credit to the firm.  The higher the ratio, the greater the assurance that short-term creditors can be paid.

Liquidity Ratios Measure short-term ability to pay maturing obligations and meet unexpected needs for cash

The ratios that are commonly used to measure a firm’s liquidity are the liquidity ratio, the quick ratio, the cash ratio and the cash-flow-from-operations ratio:

  • Current ratio – Measures a firm’s ability to pay its current debts out of total current assets:

Current Assets ÷ Current Liabilities

  • Quick ratio – Tests a firm’s short-term debt-paying ability through the use of only its most liquid (“quick”) assets:

(Cash, Cash Equivalents + Receivables) ÷ Current Liabilities

  • Cash ratio – The most conservative of the liquidity ratios as it considers only actual cash and cash equivalent balances as available for paying off current liabilities:

(Cash + Cash Equivalents) ÷ Current Liabilities

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