Liquidity ratios are financial ratios that measure a company’s ability to meet its short-term obligations and convert its assets into cash to meet its current liabilities. They provide insight into a company’s liquidity position and its ability to pay off its short-term debts.

There are several types of liquidity ratios include the current ratio, quick ratio, cash ratio. operating cash flow ratio and working capital turnover ratio.

- Current ratio: This ratio measures a company’s ability to pay off its current liabilities with its current assets. It is calculated by dividing current assets by current liabilities. A current ratio of 1:1 or higher is generally considered good, as it indicates that a company has enough current assets to cover its current liabilities.
- Quick ratio: This ratio measures a company’s ability to pay off its current liabilities with its most liquid assets (i.e., assets that can be quickly converted to cash). It is calculated by subtracting inventories from current assets and dividing the result by current liabilities. A quick ratio of 1:1 or higher is generally considered good, as it indicates that a company has enough liquid assets to cover its current liabilities without relying on the sale of inventory.
- Operating Cash flow Ratio: This ratio measures how much cash a company has generated from operating activities to cover current Liabilities. A higher ratio is desired as it implies that a company is generating more cash from its core activities to pay its current liabilities. If operating cash flows are projected to decline in the future, the company will have to look to investing & financing sources to cover the shortfall.
- Working Capital Turnover: It is calculated by dividing sales by average working capital. The sales amount comes from the income statement, while working capital is calculated as the difference between current assets and current liabilities. All else being equal, a higher working capital turnover ratio is better. Higher projected net sales in future years will cause this ratio to increase. A ratio that is too high could indicate a working capital amount that is too low.

Overall, liquidity ratios are important because they help investors, creditors, and other stakeholders assess a company’s short-term financial health and its ability to meet its financial obligations. A company with strong liquidity ratios is generally considered to be more financially stable and less risky than one with weaker liquidity ratios.