What is a liquidity ratio?

A liquidity ratio specifically measures a company's ability to meet its short-term obligations as they arise. This type of ratio evaluates the financial health of a company by determining whether it has sufficient liquid assets on hand to cover liabilities that are due in the near term, typically within one year. Common liquidity ratios include the current ratio and the quick ratio, which both provide insight into the short-term financial position of a company and its capacity to pay off current debts without needing to sell off long-term assets.

Understanding liquidity is crucial because even a profitable company can face financial difficulties if it struggles to convert its assets into cash quickly or has inadequate liquid assets to cover immediate liabilities. Thus, liquidity ratios are essential indicators for creditors and investors assessing the financial stability and operational efficiency of a business in the short run.