# What is the Degree of Relative Liquidity? ## Degree of Relative Liquidity

The Degree of Relative Liquidity, also known as the Liquidity Ratio, is a measure of a company’s ability to meet its short-term obligations using its short-term assets without raising external capital.

There are several types of liquidity ratios, each measuring liquidity in a slightly different way:

• Current Ratio: This is calculated as a company’s current assets divided by its current liabilities. A higher current ratio indicates a higher degree of liquidity.
• Quick Ratio: Also known as the acid-test ratio, this is calculated as a company’s most liquid assets (cash, marketable securities, and accounts receivable) divided by its current liabilities. It’s a stricter measure than the current ratio because it excludes inventory and other current assets that are not as easily converted to cash.
• Cash Ratio: This is the most conservative liquidity ratio, calculated as a company’s cash and cash equivalents divided by its current liabilities. This ratio measures a company’s ability to pay off its current liabilities with just its cash and cash equivalents.
• Working Capital Ratio: This is calculated as current assets minus current liabilities. A positive working capital ratio means a company has enough short-term assets to cover its short-term debt.

Each of these ratios provides a slightly different perspective on a company’s liquidity. In general, higher liquidity ratios indicate that a company is more likely to be able to meet its short-term obligations, which can be a sign of financial health. However, very high liquidity ratios can also indicate that a company is not using its assets efficiently to generate profits. As with all financial ratios, these should be used in context and in conjunction with other financial analysis tools.

## Example of the Degree of Relative Liquidity

Let’s consider a simple example using some of the liquidity ratios:

Suppose we have a company, we’ll call it XYZ Corp. Here are some of its financials:

• Current Assets: \$500,000
• Of which, Cash and Cash Equivalents: \$100,000
• Marketable Securities: \$50,000
• Accounts Receivable: \$150,000
• Current Liabilities: \$300,000

Now, let’s calculate some liquidity ratios:

• Current Ratio = Current Assets / Current LiabilitiesCurrent Ratio = \$500,000 / \$300,000 = 1.67
• Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current LiabilitiesQuick Ratio = (\$100,000 + \$50,000 + \$150,000) / \$300,000 = 1
• Cash Ratio = Cash and Cash Equivalents / Current LiabilitiesCash Ratio = \$100,000 / \$300,000 = 0.33

These ratios tell us that:

• The Current Ratio of 1.67 means XYZ Corp has \$1.67 of current assets for every \$1 of current liabilities. This suggests that XYZ Corp has more than enough short-term assets to cover its short-term liabilities.
• The Quick Ratio of 1 means XYZ Corp has \$1 of easily liquidated assets for every \$1 of current liabilities. This suggests that even without selling any inventory, the company can cover its short-term obligations.
• The Cash Ratio of 0.33 means XYZ Corp has \$0.33 in cash and cash equivalents for every \$1 of current liabilities. This suggests that the company doesn’t have enough cash on hand to meet its short-term liabilities, but keep in mind that this is a very conservative measure of liquidity.

Remember, while these ratios can provide useful insights, they should be used in conjunction with other financial ratios and analysis methods to get a complete picture of a company’s financial health. Also, it’s helpful to compare these ratios with those of other companies in the same industry, as what might be considered a healthy ratio can vary between industries.

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