How to Evaluate a Company's Financial Health: Practical Guide on Liquidity

Liquidity is a critical indicator for determining whether a company can meet its short-term financial commitments. The indices that measure this capacity are essential tools for investors and managers to make more informed decisions. Let's understand how these indicators work in practice.

The Three Main Liquidity Indicators

1. Current Index: The Basic Thermometer

The first and most well-known is the current liquidity ratio. It compares the total current assets (available resources in the short-term) with the total current liabilities (payable debts in the same period).

Formula: Current assets ÷ Current liabilities

The larger this number, the more comfortable the company's financial position is. A result above 1 means that the organization has sufficient resources to meet its commitments.

2. Understanding Dry Liquidity: A More Rigorous Analysis

When we want to be more cautious, we use the quick ratio ( also called the acid-test ). This indicator excludes inventory from the equation because inventory cannot always be quickly converted into cash.

Formula: (Box + Short-term investments + Accounts receivable) ÷ Current liabilities

The quick ratio provides a more conservative and realistic view, especially for companies with a large volume of inventory. If you want to learn how to calculate the quick ratio accurately, it is essential to use this formula for stress test scenarios.

3. Immediate Liquidity: The Most Conservative Measure

The most restrictive indicator is immediate liquidity, which considers only the cash actually available on hand.

Formula: Available box ÷ Current liabilities

This index answers a direct question: if the company needed to pay its debts today, would it be able to?

Interpreting the Results

The numbers generated by these indices tell a simple story:

• Index = 1: The company has exactly enough to cover its obligations
• Index < 1: There is a resource deficit, indicating possible financial difficulty.
• Index > 1: The position is healthy, with a margin of safety to cover commitments

However, these isolated indicators do not reveal the full story. It is essential to analyze them in conjunction with other financial metrics, compare with industry competitors, and track historical trends. In this way, you build a more robust understanding of the true financial health of an organization.