"Liquidity" (or "current position") is the measurement of a firm’s ability to service its short-term obligations through the "liquidation" of current assets. Liquidation refers to the act of turning assets into cash, that is, selling inventory and collecting receivables and amounts due to the business.
The simplest measure of liquidity is “working capital,” or total current assets minus total current liabilities. This measurement yields a dollar amount. If the number is positive, then the business has a cushion of current assets over current liabilities. A working capital shortfall may imply that a problem servicing obligations will arise during the upcoming year.
Perhaps the most commonly used measurement of liquidity is the “current ratio.”
Current Ratio = Total Current Assets / Total Current Liabilities
The current ratio is analogous to the calculation of working capital. The difference is that the cushion between current assets and current liabilities is measured as a ratio instead of a dollar amount.
A current ratio above one implies that a cushion exists between current assets and current liabilities. The higher the ratio, the greater the liquidity, since the coverage of current liabilities by current assets becomes larger.
It is also important to analyze the composition and quality of current assets. Are they comprised primarily of cash and liquid assets? Or, are most of the liquid assets comprised of receivables that may be difficult to collect or inventory which may be difficult to sell?
Liquidity ratios may also be affected by accounting policies such as whether a borrower uses LIFO, FIFO, or some other inventory valuation method.
Keep in mind that liquidity ratios are affected by seasonality and that the cash conversion cycle or the makeup of the balance sheet may affect liquidity ratios. For example, a business with a high concentration of fixed assets financed by long-term debt, but with no inventory or receivables, may appear to have liquidity issues (due to the current portion of long-term debt within the denominator of the current ratio). If fixed assets (as opposed to sales from inventory) generate consistent cash flow, then this income may be sufficient to service the debt and current obligations. In such a case, an analysis of the cash flows and the debt service coverage ratios may be a better indicator of liquidity.
For Smith Heating and Cooling, Inc., current assets total $309,000, while current liabilities add up to $275,000. This means that the company has working capital of $34,000 and a current ratio of 1.12.
In this Street Smarts article on Inc.com, Norm Brodsky argues that paying attention to working capital and the current ratio are essential to success in business.