Importance of liquidity ratios in short-term financial decision-making
Liquidity ratios are a source of information on the ability of the company to meet its short-term immediate obligations. Liquidity is a reflection of the company’s ability to meet its short-term obligations by the use of assets whose conversion to cash is an easy task. The three most common liquidity ratios include the current ratio, the quick ratio, and the networking ratio. The current ratio can be described as the ratio of current assets to the current liabilities. Current ratios are an indication of the ability of the company to satisfy its current liabilities with its current assets. When making various decisions short-term decisions such as allowing the sale of goods on debt, the current ratio will show the ability of the company to continue with its regular activities.Current ratio= Current Assets/current liabilities. The quick ratio is defined as the ratio of quick assets to the current liabilities. Quick assets are the current assets minus the inventory. Quick ratios are an indication of an indication of the ability of the firm to satisfy its current liabilities by the use of its liquid assets.Quick ratio= Current assets-Inventory/ current liabilities.
Net working capital ratio is the net working capital compared to sales. Net working capital indicates the liquid assets of the company after meeting its short-term obligations in relation to its need for liquidity. Liquidity in this case is represented by the sales.Net working capital to sales ratio= Current assets-Current Liabilities/sales In general, having more liquid assets to cover short-term liabilities indicates the likelihood of a company to be able to debts when required without running out of coffers for supporting the ongoing operations. Companies with high liquidity ratios are better positioned to handle obligations. Liquidity ratios are important in short-term decision making by allowing a company to gauge its paying capacity on a short-term basis (Stern, 2002, pg.9).
Bibliography
Stern, Stewart & Co., Accenture (Firm), & Morgan Stanley (Firm). (2002). Journal of applied corporate finance. New York, N.Y: Stern Stewart & Co.
