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Liquidity is the firm's ability to satisfy maturing short-term debt. Liquidity is crucial to carrying out the business, especially during periods of adversity. It relates to the short term, typically a period of one year or less. Poor liquidity might lead to a higher cost of financing and an inability to pay bills and dividends. The three basic measures of liquidity are (a) net working capital, (b) the current ratio, and (c) the quick (acid-test) ratio.
Net working capital equals current assets minus current liabilities.
Net working capital = current assets - current liabilities
The current ratio equals current assets divided by current liabilities. The ratio reflects the company's ability to satisfy current debt from current assets.
General rule: A declining ratio might be assign of a deteriorating liquidity problem. On the other hand, it might be the result of a paring out of obsolete inventory or other stagnant assets.
A more stringent liquidity test can be found in the quick (acid test) ratio. Inventory and prepaid expenses are excluded from the total of current assets, leaving only the more liquid (or quick) assets to be divided by current liabilities.
|Acid-test ratio =
Cash + Short-term investments + Accounts receivable