Liquidity refers to how easily assets can be converted into cash.

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It includes the ability of the management to convert its current assets into cash
in a quick, stable, and regular manner. It also deal with the ability of
management to use trade credits and stretch the payments to trade credits in
financing operating activities.

There two common calculations that falls under liquidity ratio

1. Current ratio
2. Acid ratio / quick asset
These two ratios are often grouped together by financial analysts when attempting to accurately
measure the liquidity of a company.

The current ratio indicates a company's ability to pay its current liabilities from its current assets.
It tells investors and analysts how a company can maximize the current assets on its balance
sheet to satisfy its current debt and other payables.This ratio is one used to quickly measure the
liquidity of a company. The formula for the current ratio is:
Current Ratio = Current Assets ÷ Current Liabilities

Current assets listed on a company's balance sheet include cash, accounts receivable, inventory
and other assets that are expected to be liquidated or turned into cash in less than one year.
Current liabilities include accounts payable, wages, taxes payable, and the current portion of
long-term debt.

A current ratio that is in line with the industry average or slightly higher is generally considered
acceptable.

A current ratio that is lower than the industry average may indicate a higher risk of distress or
default.

Similarly, if a company has a very high current ratio compared to their peer group, it indicates
that management may not be using their assets efficiently.

Acid Ratio
The purpose of this ratio is to measure how well a company can meet its short-term obligations
with its most liquid assets. Remember, liquid assets are those that can be quickly turned into
cash. The formula for calculating the acid ratio is:
Acid Ratio = (Cash & Cash Equivalents + Short-Term Investments + Accounts Receivable) ÷
Current Liabilities

If a business has:

 Cash = $15 million

 Marketable securities = $20 million
 Inventory = $25 million
 Short-term Debt = $15 million
 Accounts Payables = $15 million

it can easily settle each dollar on loan or accounts payable twice.

that for every $1 in current liabilities, the company has $2 in current assets. The higher the ratio,
the better the financial position of the company. Company A is in sound financial position, and
the current ratio of 2 to 1 indicates that they can pay their short-term obligations.

The higher the ratio, the better the company’s liquidity and overall financial
health. A ratio of 1.75 implies that the company owns 1.75 of liquid assets
to cover each $1 of current liabilities.

The receivables turnover ratio measures the efficiency with which a company
collects on their receivables or the credit it had extended to its customers. The
ratio also measures how many times a company's receivables are converted
to cash in a period.

A high receivables turnover ratio can indicate that a company’s collection of

accounts receivable is efficient and that the company has a high proportion of
quality customers that pay their debts quickly.

Inventory turnover shows how many times a company has sold and
replaced inventory during a given period.

This helps businesses make better decisions on pricing, manufacturing,

marketing, and purchasing new inventory.

Inventory turnover measures how fast a company sells inventory and how
analysts compare it to industry averages.

The accounts payable turnover ratio is a short-term liquidity measure used to

quantify the rate at which a company pays off its suppliers. Accounts payable
turnover shows how many times a company pays off its accounts payable
during a period.

When the turnover ratio is increasing, the company is paying off suppliers at a
faster rate than in previous periods. An increasing ratio means the company
has plenty of cash available to pay off its short-term debt in a timely manner.
As a result, an increasing accounts payable turnover ratio could be an
indication that the company managing its debts and cash flow effectively.

Operating cycle refers to number of days a company takes in converting its

inventories to cash. It equals the time taken in selling inventories (days inventories
outstanding) plus the time taken in recovering cash from trade receivables (days
sales outstanding).

Length of a company's operating cycle is an indicator of the

company's liquidity and asset-utilization. Generally, companies with longer operating
cycles must require higher return on their sales to compensate for the
higher opportunity cost of the funds blocked in inventories and receivables.

It is called operating cycle because this process of producing/purchasing inventories,

selling them, recovering cash from customers, using that cash to purchase raw
materials to produce more inventories and so on is repeated as long as the company
is in operations.

A related concept is that of net operating cycle which is also called the cash
conversion cycle. The net operating cycle subtracts the days a company takes in
paying its suppliers from the sum of days inventories outstanding and days sales
outstanding.